Director Compensation and Related Party Transactions

Related party transactions (RPTs) involve the transfer of resources, services, or obligations between a reporting company under the Securities Exchange Act and a related party (SFAS 57; IAS 24). Some of the highest profile accounting scandals, such as the ones at Enron and Adelphia, have involved RPTs. The Financial Accounting Standards Board (FASB) considers RPTs non-arm’s length transactions by their very nature and expresses concern about RPTs for potentially creating agency problems and hampering board monitoring efficacy, providing corporate insiders with the potential means to extract wealth from outside shareholders via self-dealing. Consistent with the FASB’s concern, the results from prior studies show that firms with weaker corporate governance mechanisms are more likely to engage in RPTs. These studies focus on corporate governance mechanisms such as board composition and large shareholder concentration. However, the potential effect of directors’ compensation on their ability to objectively monitor RPT activities has received little attention.

Our study fills this gap. A firm’s board of directors is responsible for protecting shareholders’ interests and mitigating agency conflicts between shareholders and management. Given that one important way to motivate directors to fulfill their board responsibility is through appropriate director compensation, a natural question is whether independent directors’ compensation is associated with related party transactions.

Directors are usually compensated by a combination of cash, stock, and options. We focus on two dimensions of compensation: (1) Director Compensation Level (DCL), which represents directors’ total compensation level, and (2) Director Equity-Based Compensation (DEC), which is measured as the proportion of equity-based compensation to total compensation.

Our study builds on two theories. On one hand, the conflict-of-interest theory predicts that high compensation level is associated with more RPTs, because it may impair the independence of directors, making them vulnerable to managers’ influence. In this case, highly compensated directors may not provide optimal oversight of managers. In addition, high levels of compensation are conducive to self-dealing. Therefore, highly compensated directors who seek private benefits are more likely to use RPTs to enrich themselves than to protect shareholders’ interests. On the other hand, the efficient contracting theory suggests that high compensation levels can attract more capable directors, providing more effective monitoring and thus leading to fewer RPTs. The results from prior studies for both U.S. and non-U.S. firms are more consistent with the conflict-of-interest theory.

Our primary argument is that although a competitive and fair compensation level and equity-based structure can attract high-caliber independent directors who can provide better monitoring, an excessive compensation level and equity-based compensation can impair outside directors’ independence, which in turn would compromise their objectivity in monitoring firm activities. First, we focus on DCL and expect a positive relation between independent directors’ compensation and the occurrence of RPTs. Next, we turn our attention to DEC. Because equity-based compensation ties the directors’ benefits to the performance of the firm, directors receiving a larger fraction of their compensation in the form of equity are expected to better monitor firm activities. Consistent with this argument, prior research finds that DEC is associated with greater investment opportunities, higher price-to-book ratio, lower implied cost of capital, and better performance. Building on these findings, we expect a negative relation between DEC and RPTs.

Employing hand-collected data for S&P 1500 firms, we find results consistent with our predictions. First, we find that DCL is positively associated with RPTs, suggesting that when directors’ pay levels are high, they are more likely to be influenced by managers and become less independent, leading to more RPTs. Second, we find that compensation comprised of a larger portion of equity is associated with fewer RPTs, suggesting that DEC aligns directors’ and shareholders’ interests.

These findings provide preliminary support for the conflict-of-interest theory. However, director compensation should be high enough to attract qualified candidates and provide sufficient incentives for directors to fulfill their board responsibility. As a result, there should exist an optimal level or mix of compensation. In an attempt to shed some light on this, we deconstruct directors’ compensation into “market” (i.e., predicted) and “excessive” compensation components. Consistent with the conflict-of-interest theory, we find that excessive compensation components are associated with more RPTs.

Next, building on prior studies that show that not all RPTs are prone to insider opportunism, we categorize RPTs by transaction type and counterparties, and examine whether there are differences in director compensation associated with the various categories. First, we divide the RPT sample into two subsamples based on counterparties: (1) RPTs with independent directors, and (2) RPTs with other parties such as executives or primary shareholders. We find  a stronger association between independent-director  compensation and the subsample of RPTs with independent directors. Second, we divide the RPT sample into two subsamples based on RPT types: (1) Business RPTs, which are closer to the firm’s core business operation, and (2) Non-Business RPTs (e.g., transactions involving loans, donations to related charities, and consulting and legal services). We find a stronger association between independent-director compensation and the subsample of  non-business RPTs. These findings corroborate our main findings.

To comply with listing requirements of the SEC and stock exchanges, U.S. public firms generally designate the board of directors or a specific committee of the board to review and approve RPTs. We expect that the effect of directors’ compensation on RPTs should be more pronounced for directors who have the authority to approve RPTs than for those who do not. Consistent with our expectations, we find that when firms designate the audit committee to approve RPTs, the compensation of audit committee members is more strongly associated with the RPTs than is the compensation of non-audit committee members.

In sum, our study provides empirical evidence on the association between independent directors’ compensation and related party transactions. Our findings suggest that overcompensating directors has an adverse effect on their independence and the effectiveness of board monitoring.

This post comes to us from Professor Ole-Kristian Hope at the University of Toronto’s Rotman School of Management, and from Ross (Haihao) Lu and Sasan Saiy at the University of Waterloo. It is based on their recent article, “Director Compensation and Related Party Transactions,” available here.

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