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Inside the Black Box: The Role and Composition Of

Inside the Black Box: The Role and Composition Of

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Published by: api-26172897 on May 19, 2009
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 Inside the Black Box: The Role and Composition of Compensation Peer Groups
Michael Faulkender
Olin School of BusinessWashington University in St. Louis
Jun Yang
Kelley School of BusinessIndiana University
We would like to thank Richard Mahoney (retired CEO from Monsanto Co.) and seminar participants atWashington University in St. Louis. We also thank Cassandra Marshall and Raj Mistry for their researchassistance. All errors are ours.
Email: faulkender@wustl.edu
Email: jy4@indiana.edu
Inside the Black Box: The Role and Composition of Compensation Peer Groups
This paper documents the features of compensation peer groups and demonstratesthat they play a significant role in determining CEO compensation. Anecdotally, weknow that compensation peer groups have had a growing role in determining executivecompensation but only recently have firms begun voluntarily disclosing the members of these peer groups. To empirically test their role, we hand-collect a sample of 83 of theS&P 500 firms that provided explicit lists of compensation peer firms in their fiscal 2005disclosures. Results show that inclusion of the group’s median compensation more thantriples the portion of the variation in CEO cash compensation that can be explained,dominating measures such as size and firm performance. The average peer group hasmore than eleven firms in it with just over half of them coming from the same 3-digit SICas the firm. Univariate analysis suggests that firms forego lower paid potential peers intheir same industry in favor of higher paid peers outside of their industry whenconstructing the peer groups. In multivariate regression analysis, this result carriesthrough as we find that even after controlling for industry and relative size, peer groupcomposition is significantly affected by the level of compensation of the potential peers.Firms appear to select high paid peers as a mechanism to increase CEO compensationand this effect is strongest in firms with low GIM index values, low E-scores, and low blockholder ownership. We conclude that in firms with weak internal governance, CEOsare most able to create benchmarks (compensation peer group compositions) that helpgenerate higher compensation for themselves. Given that disclosure of peer groupcomposition had until recently been voluntary, our results are likely to underestimate theextent to which peers are selected by characteristics seemingly unrelated to managerial performance or their reservation wage.
1. Introduction
Recent growth in CEO compensation, especially the dramatic increases for top paid CEOs, have led many to question whether CEOs have too much influence over their own compensation. The pay package of $187 million for former New York Stock Exchange Chairman Richard Grasso, and the $210 million golden parachute for theousted, and arguably mediocre performing, former Home Depot CEO generated notable press coverage and have led us to wonder who sets CEO pay. The academic literature onthis issue is exploding, but has not reached a consensus. Many view the pay increases asa sign of CEOs' abuse of power,
but others argue that the compensation simply reflectsmarket equilibrium where the board optimally sets up CEO pay.
Theoretically, the pay setting process is quite transparent in the US. For a publiclytraded company, the initial pay recommendations typically come from the company’shuman resources department, often working in conjunction with outside compensationconsultants. If accepted by the compensation committee, the recommendations are then passed to the full board of directors (BOD) for approval. This process seems at least to provide the management with opportunities to influence CEO pay via the initialrecommendations.
To address this potential influence, the NYSE instituted a new rulethat took effect in 2003 that bans CEOs of NYSE-listed firms from sitting oncompensation committees as well as from choosing external consultants. However, evenwith this new rule in place and independent directors who “approach their jobs with
See, for example, Bebchuk and Fried (2003, 2004), Bertrand and Mullanaithan (2001).
See, for example, Murphy and Zabojnik (2004), Oyer (2004), Baranchuk, MacDonald and Yang (2006),and Gabaix and Landier (2006).
The empirical evidence on whether CEOs influence their pay setting is somewhat mixed. Focusing on therole of compensation committees, O’Reilly, Main, and Crystal (1988), Main, O’Reilly, and Wade (1995),and Newman and Mozes (1997) suggest the existence of the influence; while Anderson and Bizjak (2003)suggest the opposite.

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