Corporate executives are responsible for seeking and acting on business opportunities and investment initiatives (often called company “projects”). However, there is a danger that they will take on too many projects, which diminishes the overall quality of projects presented for board approval. This occurs most often when executives have ambitions of empire-building, driven by the promise of greater compensation and other rewards. The risk is that boards will approve average-quality projects, ultimately leading to overinvestment. In a new article, we analyze how incentive contracts for directors can mitigate these problems.

Imposing liability burden and protection

Our analysis reveals that optimal incentive contracts affect project quality by allocating liability burdens borne by managers and directors in case of project failure. Thus, the pivotal aspect of contract design revolves around how liability burdens are allocated within the leadership team.

Liability is a nuanced issue. Often, companies insure their officers from liability, but this is considered one of the most controversial and least understood governance tools (Li, Yang, and Zhu, 2022). The current practice is to “vote case-by-case on proposals of director and officer indemnification, liability protection, and exculpation” (ISS United States Proxy Voting Guidelines: Benchmark Policy Recommendations, p. 27).  We agree with this view and recommend strong directors’ liability protection when the optimal contracts primarily focus on the CEO’s incentives to search for better-quality projects. In contrast, we recommend weak directors’ liability protection when the optimal contracts focus on directors’ incentives to approve projects. The main driving force behind this outcome is that improving the quality of undertaken projects can be achieved by strong motivation (in the form of financial punishment when the company performs poorly) of either the board or the CEO (but never both). In cases where it is optimal to impose a liability burden on the CEO,  the board gets to enjoy liability protection. And vice versa.

Paradoxically, we support strong liability protection for directors concerned about company growth (e.g., entrepreneurs) and low liability protection for directors concerned about monetary damages. The simple intuition behind this observation is that financial and non-financial incentives often reinforce each other: Directors concerned about their reputation tend to approve higher-quality projects and should be optimally protected from liability. We also find, though, that a significant increase in reputation concerns may lead to the reallocation of liability from the CEO to the board. This explains why fine-tuning the level of liability protection is not trivial: Changes in the board characteristics may have different implications on board compensation and liability protection.

We also make predictions about the optimal board composition. Suppose the decision on liability protection has already been made. Will firm value increase by appointing directors with mild non-financial concerns or with severe ones? Our analysis provides a clear-cut answer in line with the complementarity perspective: When the imposed financial liability is weak, it is optimal to reinforce the non-financial aspect by appointing reputationally concerned directors. In contrast, when the imposed liability protection is strong, it is optimal to appoint rather entrepreneurial-style directors whose primary role is to advise management on company growth.

Conclusions

So, what is the optimal level of directors’ liability protection? Our analysis yields three recommendations: First, liability burdens must be minimized; if senior management is held liable, the board should be protected from liability, and vice versa. Second, when the primary concern is motivating managers to carry out extensive and complex investment projects, directors should be more involved in project selection. To that end, they should face more severe consequences for violating their fiduciary duties. Third, non-financial and financial incentives are complementary: a board with a significant career and other reputation concerns operates better when protected from liability.

REFERENCES

1. Gregor, Martin and Michaeli, Beatrice, Board Compensation and Investment Efficiency. 2024. Available at SSRN: https://ssrn.com/abstract=4717755 or http://dx.doi.org/10.2139/ssrn.4717755.
2. ISS United States Proxy Voting Guidelines: Benchmark Policy Recommendations, At: https://www.issgovernance.com/file/policy/active/americas/US-Voting-Guidelines.pdf?v=1
3. Li, T., Yang, T., Zhu, J. 2022. Directors’ and officers’ liability insurance: Evidence from independent directors’ voting. Journal of Banking & Finance, 138, 106425.

This post comes to us from professors Martin Gregor at Charles University, Prague, and Beatrice Michaeli at the University of California, Los Angeles. It is based on their recent article, “Board Compensation and Investment Efficiency,” available here.