The CEO compensation paradox: Evidence from a natural experiment in corporate governance

Abstract

In this paper, we examine the impact of mandated board independence on total CEO compensation by exploiting the 2003 exchange mandate requiring publicly traded firms to adopt outsider-controlled boards as a natural experiment in corporate governance. Using a difference-in-differences framework on a panel of 1,113 U.S. firms from 1997 to 2012, we compare firms required to restructure their boards with firms that were already compliant. The results indicate that the mandate had a statistically significant effect on CEO compensation, with total CEO pay increasing by approximately 7.6 percent among treated firms. These findings are consistent with the optimization view of executive compensation, which suggests that stronger governance mechanisms increase monitoring intensity, risk exposure, and accountability, requiring higher compensation to attract, retain, and motivate executives. In contrast to the managerial-power view, which predicts that stronger governance should constrain executive pay, the evidence indicates that governance reforms can lead to higher, rather than lower, compensation levels. Overall, we provide causal evidence that governance reforms reshape, rather than simply constrain, executive compensation, highlighting the importance of evaluating corporate governance and CEO pay as an integrated and jointly determined system. These findings have important implications for policymakers and practitioners, as regulatory interventions intended to strengthen governance may produce unintended consequences for executive compensation design.