Gender quotas, independence mandates, and diversity requirements for corporate boards force companies to vie for qualified directors by offering a range of financial and non-financial perks. Competition for a limited pool of qualified candidates forces companies to increase the compensation they offer to these candidates and dig deeper into the shareholders’ pockets. Thus, the compliance costs for diversity requirements can be significant. For instance, compliance with California Senate Bill No. 826 (SB 826)—the first gender diversity quota in the United States—In addition, board composition requirements can lead to undesired outcomes: post-SB 826, newly appointed female directors in California had fewer board responsibilities when compared with their counterparts in non-California firms. Such outcomes undermine the intended effects of board mandates. Our paper introduces a fresh perspective on the intersection between board mandates, the scarcity of qualified directors, and the efficiency of their monitoring role.
Encouraging directors to oversee CEOs effectively necessitates imposing liabilities for poor firm performance. For directors to be willing to accept such terms, companies have to offer significantly higher rewards for good performance, especially through stock and stock options. This means high overall compensation. For instance, higher liability risks and more strict independence standards were associated with the average total compensation of S&P 500 directors increasing from $245,000 to $321,000 and a 40% increase in stock awards over the last ten years. In other words, effective monitors receive excess pay, commonly called “rents” in the literature. The size of rents also hinges on the market pay, which is influenced by the scarcity of directors. If there is an abundance of qualified directors, market pay is low, and rents are large because the gap between incentive pay and market pay is large. The incentive pay is relatively costly for the company. Conversely, when there is a shortage of directors, rents diminish because the gap between incentive pay and market pay is narrower, and the incentive contracts are more affordable.
Of course, companies can choose not to incentivize monitoring through liabilities and reduce the pay to their boards. Besides scarcity, when is it optimal not to do so? In corporate governance, it is widely acknowledged that there is no one-size-fits-all approach; optimal arrangements depend on the company’s and industry’s unique characteristics. Our results reveal that directors’ reputation concerns—as prior literature suggests, are reflected in age, media visibility, and company size—lead shareholders to offer incentive contracts that enhance the board’s monitoring. The results suggest that reputation concerns strengthen the impact of financial incentives on monitoring, establishing a positive association with the sensitivity of director compensation to performance.
Overall, our study contributes to the understanding of how board composition requirements affect optimal board compensation, optimal board monitoring intensity, and firm performance—with particular emphasis on the efficiency of investment decisions. One of the most novel takeaways is that director scarcity affects the board monitoring level. When the pool of board candidates is limited, firms optimally provide stronger incentives to the board, which we find is associated with stronger monitoring intensity. The traditional perspective has been different: board mandates increase the monitoring intensity because they address frictions in the candidate selection process—e.g., those associated with the CEO’s control over it. We find that monitoring intensity increases even in the absence of these frictions. That is, even when the CEO has no control over the candidate selection, mandates are associated with boards that are better monitors. Our prediction is also completely independent of another standard argument that new directors change the board by bringing new information and promoting new perspectives. In our model, higher monitoring intensity would arise even if the new directors were identical to the incumbents in terms of preferences and expertise.
In summary, we find that firms are more willing to pay high overall compensation when competing over a scarce pool of director candidates. With high overall compensation, it is optimal to structure the compensation so that directors can bear liability in times of poor firm performance and thus be more effectively motivated to screen for higher-quality projects. This, in our view, is an overlooked positive effect of board and independence requirements.
Martin Gregor is an Associate Professor of Economics and Finance at Charles University, Prague. He works on topics in corporate finance, organizational economics, and accounting and economics.
Beatrice Michaeli is an Associate Professor of Accounting at Anderson School of Business at University of California, Los Angeles. She studies financial reporting, voluntary disclosure, performance measurement, incentives, and contracting.
