In our paper Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy, which was recently made publicly available on SSRN, we consider new explanations for the puzzling result that a majority of misreporting CEOs retain their jobs.  We extend the literature by investigating the role of directors’ both personal and reputational incentives in the CEO retention decision.  Overall, our analysis improves our understanding of the CEO retention decision by 30 to 40% relative to a benchmark model based on the severity of the misreporting, the firm’s performance and risk characteristics, and traditional measures of the strength of corporate governance.

We show that two types of personal benefits make conventionally independent directors less likely to remove CEOs: loss avoidance on equity-contingent wealth and increased compensation. First, we find that in firms where independent directors emulate CEOs’ trading behavior and also engage in abnormal insider selling over the misreporting period, CEOs are 13.6% more likely to be retained.  We view independent directors’ trading as suggestive of collusion because, like CEOs and other executive directors, they personally benefit by selling their equity at inflated prices during the period over which earnings are misreported.  To the extent that the misreporting sustains the firm’s overvaluation, the fact that directors engage in abnormal selling suggests they have access to negative information about the firm that they do not reveal to shareholders.  We posit that independent directors prefer not to attract attention to their own abnormal selling.  Thus, even though dismissing the CEO could enhance shareholder value by restoring credibility, directors whose trading actions align with those of CEOs have weaker incentives to replace the CEO.

…continue reading: Why Do CEOs Survive Corporate Storms?

In our forthcoming Journal of Financial Economics paper entitled “Inside the black box: the role and composition of compensation peer groups” we investigate how much compensation peer groups explain observed variation in CEO compensation and what determines the composition of these groups. Effective December 15, 2006, the SEC required that firms disclose “Whether the registrant engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies).” This study is the first to collect and examine the list of compensation peer companies used by the S&P 500 firms and S&P MidCap 400 firms in their first fiscal year ending after the compliance date of December 15, 2006.

We find that the median compensation of the peer group generates significant incremental explanatory power in understanding cross-sectional variation in the observed CEO compensation among disclosing firms even after including controls for CEO labor market conditions. We find that CEOs whose pay was below the median pay level of their counterparts in companies of similar size and in the same industry receive pay raises that are larger in both percentage and dollar terms. In contrast, having actual compensation peer group membership enables us to demonstrate that peer companies outside the firm’s industry and size group also have a significant influence on executive compensation.

When we examine the composition of peer groups, we find that firms select companies in the same industry, of similar size, and with a history of observed talent flows between them to be members of their compensation peer groups. Using both multivariate probit models and a propensity score matching (PSM) approach, we show that the level of CEO compensation at a potential peer company is statistically significant in determining its likelihood of being chosen as a compensation peer, after controlling for industry, size, visibility, talent flows and CEO characteristics. In other words, compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.

One interpretation of our results is that entrenched CEOs in firms with weak corporate governance are likely to have more power to influence their own compensation. An alternative interpretation of our findings is that higher CEO compensation (for more complex firms) is likely to be an equilibrium result in a well-functioning labor market. To distinguish between these two theories, we examine the variation in pay differences between selected and unselected peers across measures of corporate governance. We find that highly paid potential peers are more likely to be chosen as compensation peers by firms where the peer group is smaller, where the CEO is the Chairman of the BOD, where the CEO has been in the post longer, and where directors are busier serving on multiple boards.

The full paper is available for download here.