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Do Generalist CEOs Magnify Boardroom Backscratching?

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Abstract

Boardroom backscratching, or cronyism, is an unethical practice where CEOs conspire with directors to receive remuneration beyond performance- and market-related factors. Premised on the theory of planned behavior, this study investigates whether CEO generalist experience magnifies the likelihood of boardroom backscratching. Using 9482 firm-year observations spanning 1999–2018, our analysis shows that firms with greater CEO generalist managerial experience are more likely to engage in boardroom backscratching, via both cash- and equity-based compensation. We provide further evidence that backscratching firms with CEOs that possess greater generalist experience tend to overinvest, particularly via non-capital expenditure, as a channel for empire building and private rent extraction. We also find that a higher portion of female independent directors sitting on the board and the compensation committee mitigates the positive relationship between CEO generalist managerial experience and boardroom backscratching, which we attribute to greater ethicality of, and increased monitoring exercised by, female independent directors.

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Notes

  1. In this study, we use the terms ‘boardroom backscratching’ and ‘boardroom cronyism’ interchangeably.

  2. For instance, Abigail Disney, the granddaughter of Disney’s co-founder, slammed the CEO Bob Iger’s $65.6 million total compensation for the 2018 fiscal year as ‘insane,’ given that it is approximately 1424 times Disney median workers’ pay (Feiner, 2019). Meanwhile, the Walt Disney Company has been scrutinized over the compensation paid to its directors (Bilbao, 2015). In tandem, a shareholder lawsuit was filed against Goldman Sachs for the excessive pay to its independent directors, which was nearly double the average compensation of independent directors of U.S. peer companies, while those peer companies reported superior financial performance than Goldman Sachs (Huskins, 2019). Despite these public outcries, executive pay experts and corporates defended attractive pay as necessary for corporates to win the war for global talent (Rhodes and Fleming, 2018).

  3. Alternatively, we value director stock options in the same manner that Core et al. (1999) value CEO options, namely at 0.25 times the exercise price. This alternative specification produces results qualitatively similar to our main findings.

  4. The first component of PCA has an Eigenvalue of 2.609 (2.984) and explains 52.2 percent (59.7 percent) of the variation in the five individual employment attributes used in our sample (in the Custódio et al. (2013) sample). The loadings on the number of positions, number of firms, number of industries, the past CEO experience indicator, and the conglomerate experience indicator are 0.614 (0.800), 0.890 (0.931), 0.887 (0.921), 0.579 (0.649), and 0.565 (0.456), respectively, in our sample (in the Custódio et al. (2013) sample).

  5. Consistent with prior studies (e.g., Custódio et al., 2013), we standardize the first component of PCA to ease interpretation of the economic significance of our results. The minimum (maximum) value for CEO_GE is -1.978 (3.819). Our minimum CEO_GE value would describe a CEO who possesses the lowest generalist experience in our sample. This CEO is likely to have scored zero across all of the five individual employment attributes of a CEO, and would represent a CEO that has only recently entered the public company labor market. In contrast, a CEO with a high CEO_GE score in our sample would have worked in multiple companies, across multiple positions and industries, served as a CEO prior to this appointment and likely worked for a conglomerate.

  6. For reference, moving from the 25th percentile to the 75th percentile of CEO generalist experience increases the predicted likelihood of boardroom backscratching by 3.81 percent, or 13.37 (= 0.0381/0.285) percent of the average boardroom backscratching value in our sample. Moving from the minimum to the maximum value of CEO generalist experience increases the predicted likelihood of boardroom backscratching by 16.06 percent, or 56.35 (= 0.1606/0.285) percent of the average boardroom backscratching value in our sample.

  7. In support, we stratify our unmatched sample into those firms deemed to be hiring generalist CEOs (i.e., CEO_GE is above the yearly median) and specialist CEOs (i.e., CEO_GE is below the yearly median) and find (untabulated) statistically significant differences between the two sub-samples across all Model (2) control variables except Institutions and ln(CEO_Tenure).

  8. For instance, Kempf et al. (2016) claim that managers are more likely to extract private rents when institutional investors face time and monitoring constraints due to multiple blockholdings. Irani and Oesch (2016) demonstrate that while analyst coverage discourages accrual-based earnings management it induces managers to engage in real earnings management to boost earnings and meet analysts’ expectations. Collins et al. (2018) provide evidence of real earnings management being used as a tool by powerful CFOs to bypass monitoring mechanisms, including board independence, to exploit and camouflage equity-based overcompensation.

  9. A further untabulated analysis shows that the positive relationship between institutional holders and boardroom backscratching is driven by transient investors characterized with short-term horizons that drive managerial myopic and opportunistic behavior (Bushee, 1998), while we find no evidence that dedicated investors focusing on the firm’s long-term growth (Borochin and Yang, 2017) are effective in curbing boardroom backscratching.

  10. Given that our results may be non-linear and moderated by certain firm characteristics, such as size, we expand Model (2) with firm size squared (ln(Assets)2). On one hand, larger firms may afford generalist CEOs greater resources for boardroom backscratching. On the other hand, smaller firms may provide generalist CEOs with greater opportunity to capture the board due to less rigorous internal corporate governance and less intensive external monitoring. Untabulated analysis shows that our results remain robust to the inclusion of (ln(Assets)2) that accounts for potential non-linearity moderated by firm size.

  11. As further analysis, we lag the independent variable and all control variables by one year. Upon doing so, our findings are qualitatively similar to those reported in Columns 4 and 5 of Table 4.

  12. Correlations (untabulated) between our first-stage regressors and second-stage control variables indicate non-zero correlations between numerous variables at various significant levels.

  13. Chen et al. (2018) also suggest estimating a single-step, as opposed to a two-step, model as an alternative procedure, whereby CEO_GE is added as the variable of interest in Model (1). Such an approach is an appropriate alternative to a two-step model when only one first-stage regression is necessary to construct the dependent variable of the second-stage model. In our case, however, we calculate two types of first-stage residuals, namely excess CEO total compensation and excess average director total compensation, both of which are components of the dependent variable (i.e., boardroom backscratching) of our second-stage model. Adding CEO_GE to Model (1), and separately estimating Model (1) in the context of CEO and director compensation, would allow us to understand the association between CEO generalist experience and CEO and director compensation individually, but not the association between CEO generalist experience and concurrent excessive CEO and director compensation. As such, a single-step model is not appropriate in our setting.

  14. As evident from Models (1) and (2), there is uniformity in the measurement of some first-stage regressors and second-stage control variables (i.e., ROA, PPE, CEO_Female, ln(CEO_Tenure)) and similarity between others (i.e., Debt, Leverage, and Stock_Return). Where there is similarity between first-stage regressors and second-stage control variables, we use the first-stage regressor construct for alternative procedure (2) rather than the second-stage control variable.

  15. We use the absolute value of residuals for our underinvestment sub-sample for ease of interpretation, as it ensures consistency with our overinvestment sub-sample.

  16. Similar to Biddle et al. (2009), we estimate Model (4) without industry and year fixed effects because Model (3) residuals are computed by industry and year. Including year and industry fixed effects in Model (4) slightly improves the statistical significance of our results.

  17. We use a dichotomous variable for ease of interpretation of the economic significance of our findings. Results using our standardized continuous measure of CEO generalist experience yield similar results.

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Authors and Affiliations

  1. Faculty of Business and Law, Deakin University, 221 Burwood Highway, Burwood, VIC, 3125, Australia

    Egor Evdokimov & Edwin KiaYang Lim

  2. Department of Accounting, Monash University, 900 Dandenong Rd, Caulfield East, Victoria, 3145, Australia

    Dean Hanlon

Authors
  1. Egor Evdokimov
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  2. Dean Hanlon
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  3. Edwin KiaYang Lim
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Correspondence to Dean Hanlon.

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Appendix

Appendix

Summary of the variables

Variable

Definition

Boardroom backscratching model (Model 2)

Dependent variables

 BC_Totalt

A dichotomous variable that equals one if board directors and the CEO receive excessive total compensation relative to economic determinants, and zero otherwise

 BC_Casht

A dichotomous variable that equals one if board directors and the CEO receive excessive cash compensation relative to economic determinants, and zero otherwise

 BC_Equityt

A dichotomous variable that equals one if board directors and the CEO receive excessive equity compensation relative to economic determinants, and zero otherwise

Independent variables

 CEO_GE,t

The first principal component score of five measures of a CEO’s generalist experience (i.e., the number of different past (1) positions, (2) firms, and (3) industries (four-digit SIC level) in which the CEO worked; (4) whether the CEO held a CEO position at a different company prior to current appointment; and (5) whether the CEO worked for a conglomerate)

 CEO_GE_Dt

A dichotomous variable that equals one if CEO_GE is above the sample median, and zero otherwise

Moderating variables

 F_Ind_Ratio

The proportion of independent female directors

 F_Ind_Comp_Ratio

The proportion of independent female directors on the compensation committee

Control variables

 Institutionst

The proportion of shares held by institutional investors

 ln(Analysts)t

The natural log of the number of financial analysts following plus one

 Indep_Ratiot

The ratio of independent directors to total directors

 ln(Assets)t

The natural log of total assets

 ln(Firm_Age)t

The natural log of firm age plus one, where firm age is defined as the difference between the first year the firm was listed on CRSP and the current year

 PPEt

The ratio of gross property, plant, and equipment (PPE) to total assets

 MBt

The ratio of market-to-book equity

 FCFt

The ratio of operating cash flows minus capital expenditure to the market value of equity

 R&D_Dt

A dichotomous variable that equals one if investment in R&D expenditure is non-missing, and zero otherwise

 Leveraget

The ratio of long- plus short-term debt to total assets

 ROAt

The ratio of net income to opening total assets

 Stock_Returnt

The buy and hold stock return for firm i from year t−1 to year t adjusted for dividends and splits

 Zscoret

Altman’s (1968) financial distress score

 ln(CEO_Age)t

The natural log of CEO age

 ln(CEO_Tenure)t

The natural log of the number of years the CEO has been with the firm as the CEO

 CEO_Femalet

A dichotomous variable that equals one if the CEO is a female, and zero otherwise

 CEO_Dualityt

A dichotomous variable that equals one if the CEO is also chair of the board, and zero otherwise

Compensation models to capture boardroom backscratching (Model 1)

Dependent variables

 Director_Compt+1

The base cash compensation plus the value of stock and options granted for external directors

 CEO_Compt+1

The sum of salary, bonus, the total value of restricted stock granted, the total value of stock options granted using a Black–Scholes model, long-term incentive payouts, and all other payments provided by Execucomp

Control variables

 Qt

The market value of common stock plus the book value of total debt divided by the book value of total assets

 ROAt

The ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to total assets

 Mean_ROAt,t−2

The average ROA, as defined above, for years t−1, t−2, and t−3

 Stock_Returnt,t−2

The buy and hold stock return for the past three years, equal to the ratio of the price at the end of year t to the end of year t−3, adjusted for dividends and splits, minus 1

 Cash_Flow_Riskt+1

The standard deviation of first differences in ROA, as defined above, for the prior eight years

 Stock_Volatilityt+1

The Black–Scholes volatility measure given by Execucomp

 ln(Sales)t

The natural log of sales in the year prior to the compensation observation

 ln(Employees)t

The natural log of the number of employees in the year prior to the compensation observation

 R&Dt

The ratio of research and development expenditure to total assets. Missing values are replaced with zero

 Advertisingt

The ratio of advertising expenditure to total assets. Missing values are replaced with zero

 Debtt

The ratio of total debt to total assets

 PPEt

The ratio of PPE to total assets

 Investmentt

The ratio of capital expenditure to total assets

 CEO_Own_Pctt

The proportion of shares owned by the CEO

 CEO_Internalt

A dichotomous variable that equals one if the CEO joined the company more than a year before he or she became CEO, and zero otherwise

Investment efficiency models (Models 3 and 4)

Dependent variables

 Investmentt+1

The sum of research and development expenditure, capital expenditure, and acquisition expenditure less cash receipts from sale of PPE multiplied by 100 and scaled by opening total assets

 Capext+1

Capital expenditure multiplied by 100 and scaled by opening total assets

 Non-Capext+1

The sum of research and development expenditure and acquisition expenditure multiplied by 100 and scaled by opening total assets

 InvEfft+1

Residuals from regressing Investment on revenue growth rate (%RevGrowth), a dichotomous variable capturing negative revenue growth (NEG), and their interaction term, where positive (negative) model residuals are referred to as Overinvestment (Underinvestment)

Control variables

 %RevGrowtht

Revenue growth rate in year t

 NEGt

A dichotomous variable that equals one for negative revenue growth, and zero otherwise

 σ(CFO)t

The standard deviation of operating cash flows scaled by average total assets from year t−5 to t−1

 σ(Sale)t

The standard deviation of sales scaled by average total assets from year t−5 to t−1

 σ(Investment)t

The standard deviation of Investment from year t−5 to t−1

 Tangibilityt

The ratio of PPE to total assets

 K-structuret

The ratio of long-term debt to the sum of long-term debt and the market value of equity

 Ind K-structuret

Mean K-structure for firms in the same SIC 3-digit industry

 CFOsalet

The ratio of operating cash flows to sales

 Slackt

The ratio of cash to PPE

 Dividendt

A dichotomous variable that equals one if the firm paid a dividend in year t, and zero otherwise

 OpCyclet

The natural log of ((receivables to sales plus inventory to COGS) multiplied by 360)

 Losst

A dichotomous variable that equals one if net income before extraordinary items is negative, and zero otherwise

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Evdokimov, E., Hanlon, D. & Lim, E.K. Do Generalist CEOs Magnify Boardroom Backscratching?. J Bus Ethics 181, 221–247 (2022). https://doi.org/10.1007/s10551-021-04895-0

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