The CEO, the Board of Directors and Executive Compensation: Economic and Psychological Perspectives

How do boards of directors of large US corporations set the compensation levels for chief executive officers (CEOs)? Economic theories are based on the presumption that an independent board of directors will safeguard shareholders' interests and minimize opportunism on the part of management. Explicit in these formulations is the assumption that outside or independent directors (i.e. non-management directors) are more able to do this than insiders. But is this a reasonable assumption? Drawing on psychological theories of small group dynamics and social influence, we investigate the extent to which the board of directors may be influenced or captured by the CEO such that executives receive higher levels of compensation than performance or economic theories would predict. Results of a review of the descriptive evidence for the operation of boards and two empirical studies suggest that social influence may be responsible for significant increments in CEO compensation beyond what economic theories predict. The implications of these findings for both theories of governance and the operation of boards of directors is discussed.