The association between director overcompensation and related party transactions prone to insider opportunism

Monday, May 13, 2019

business people walking around
Related party transactions (hereafter RPTs) involve a transfer of resources, services, or obligations between a reporting entity and a related party (SFAS 57; IAS 24). Although not all RPTs are “bad," prior research documents that some RPTs reflect insider opportunism and are harmful to shareholders. The Financial Accounting Standards Board (FASB) considers RPTs as non-arm’s length transactions by their very nature and expresses concern about some RPTs for potentially creating agency problems and hampering board monitoring efficacy, providing corporate insiders with the potential means to extract wealth from outside shareholders via self-dealing. 

A firm’s board of directors is responsible for protecting shareholders’ interests and mitigating agency conflicts between shareholders and management. The potential effect of directors’ compensation on their ability to objectively monitor RPT activities has received little attention. Given that one important way to motivate directors to fulfill their board responsibility is through appropriate director compensation design, a natural question is whether independent directors’ compensation is associated with related party transactions. Employing hand-collected RPT data from proxy statements for S&P 1500 firms, Assistant Professors Haihao Lu and Sasan Saiy from School of Accounting and Finance and their coauthor, Professor Ole-Kristian Hope (University of Toronto), examine this association.

They find that independent directors' compensation is significantly associated with RPTs. Specifically, they find that while the level of compensation is positively related to RPTs, the equity-based compensation is not associated with RPTs. Next, they decompose the compensation measures into "market" (i.e., predicted) level and "excessive" components and find that the results are driven by the excessive components. They also find that this association between RPTs and director compensation is moderated by corporate governance mechanisms, suggesting that the association between director compensation and RPTs reflects a conflict of interest between insiders and shareholders. Lastly, they find some evidence that the effects of director compensation on RPTs are stronger for RPTs with directors compared with RPTs with non-directors, for nonbusiness RPTs compared with business RPTs, and for ex-post RPTs compared to ex-ante RPTs.

This study provides empirical evidence on the association between independent directors’ compensation and related party transactions suggesting that overcompensating directors has an adverse effect on their independence and the effectiveness of board monitoring.

Ole-Kristian Hope, Haihao Lu, and Sasan Saiy. 2019. Director Compensation and Related Party Transactions. The Review of Accounting Studies, forthcoming.