What are friends for? CEO Networks, Pay and CG

1. What are friends for?CEO Networks, Pay and CG Rayna Brown*, Ning Gao†, Edward Lee†, Konstantinos Stathopoulos† *Department of Finance University of Melbourne †Accounting and Finance Group, Manchester Business School Correspondent Author Details: Address: Accounting and Finance Group, Manchester Business School, MBS Crawford, Booth Street East, M15 6PB, Manchester, UK. Email: k.stathopoulos@mbs.ac.uk

2. Motivation The empirical literature on executive pay has identified company and industry characteristics that affect the level and structure of compensation contracts. Consistent with agency theory predictions, firm size and monitoring difficulties appear to be dominant in explaining pay practices (Demsetz and Lehn, 1985; Himmelberg et al., 1999; Core and Guay, 2002). BUT the Managerial Power Approach (Bebchuk et al., 2002) argues that managerial power and arm’s length relationships determine the final outcome in pay contracts. K. Stathopoulos, EFM Symposium 2009 - Cambridge

3. Objectives of the paper Test the predictions of the managerial power approach. • Identify an “accurate” measure of managerial power. • Apply it to US pay practices. • Examine the role of corporate governance in limiting managerial power. K. Stathopoulos, EFM Symposium 2009 - Cambridge

4. Measuring “Power” • Bebchuk et al. (2002) argue that power stems from connections within a firm that are created through “bonds of interest, collegiality or affinity” between the CEO and other board members. • Borrowing our arguments from the Social Network Theory we argue that CEOs will also derive power from connections outside the firm. We claim that it is the power in the managerial labour market that matters. K. Stathopoulos, EFM Symposium 2009 - Cambridge

5. Measuring “Power” We measure the number of contacts, i.e. the total number of people, the CEO is acquainted with through current and past employment, education and other types of social activities. Characteristics • Cumulative • Direct ties • Weak ties This measure neither underestimates the size of the network by ignoring past ties nor overestimates it by including indirect ties. K. Stathopoulos, EFM Symposium 2009 - Cambridge

6. Prior Studies Most studies on pay and networking use some measure of board interlocks as their proxy of social networks. They find a positive relationship between interlocked boards and pay levels (Hallock, 1997; Core et al., 1999; Fich and White, 2003; Barnea and Guedj, 2006; Larcker et al., 2006; Hwang and Kim, 2008; Horton et al., 2009). Only Hwang and Kim (2008) examine the pay-performance sensitivity of the contract. They document an inverse relationship. K. Stathopoulos, EFM Symposium 2009 - Cambridge

7. Data • 1,366 observations for the US (fiscal year 2005). • BoardEx database provides the CEO networking, tenure and age variables. • Execucomp database provides all the pay data. • Firm level market and accounting data is extracted from CRSP-Compustat. K. Stathopoulos, EFM Symposium 2009 - Cambridge

8. CEO network and pay level K. Stathopoulos, EFM Symposium 2009 - Cambridge

9. CEO network and PPS K. Stathopoulos, EFM Symposium 2009 - Cambridge

10. CEO network, PPS and CG K. Stathopoulos, EFM Symposium 2009 - Cambridge

11. Robustness checks K. Stathopoulos, EFM Symposium 2009 - Cambridge

12. Conclusions • A bigger social network leads to higher pay levels and lower pay-performance sensitivity. • Shareholder protection can reduce the effect of CEO power on the setting up of the compensation contract. • Our measure of power explains better pay practices compared to measures of current ties only or CEO ownership. K. Stathopoulos, EFM Symposium 2009 - Cambridge