Through the Grapevine: Network Effects on the Design of Executive Compensation Contracts

Abstract

Effective design of executive compensation contracts involves choosing and weighting performance measures, as well as defining the mix between fixed and incentive-based pay components, with a view to fostering talent retention and goal congruence. The variability in compensation design observed in practice is significantly lower than it would be predicted by contracting theory. This is likely due to indirect constraining pressures, which cannot be completely explained by industry affiliation or peer group membership. I posit that network connections involving corporate boards operate as a conduit for these pressures. Using information disclosed in proxy statements of publicly traded companies, and a vectorial approach to measure compensation similarity, I predict and find that firms that are connected by board interlocks, hiring the same compensation consulting firm, or sharing a blockholder, exhibit a higher degree of similarity in the design of executive compensation contracts than what would be predicted by similarities in organizational characteristics. The relative prominence of the connectors within the respective networks moderates the network effects on the degree of compensation similarity. Finally, I show that the market responds positively to compensation similarity, although it is associated with excess CEO compensation.