Board Structure, Executive Compensation and Firm

Performance in Emerging Economies: Evidence from

India

Arijit Ghosh Indira Gandhi Institute of Development Research

Gen. A.K. Vaidya Marg, Goregaon (East),

Mumbai-400065, India

Ph. No. 91-9819090266

Email: arijit@igidr.ac.in

August 2003

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Board Structure, Executive Compensation and Firm

Performance in Emerging Economies: Evidence from

India

Abstract:

This paper examines the empirical relationship between board structure, CEO compensation and firm performance in the context of an emerging economy, India. Using panel data on 462 manufacturing firms from the Indian corporate sector for the period 1997 to 2002 I would like to explore two specific issues. First, I have examined how the structure of the corporate board in terms of size and proportion of non-executive directors affect the firm performance. This study also finds that the identity of the Chief Executive Officer matters; if the CEO is related to the promoter(s), the company performs better. Second, I have examined how the level and different components of executive compensation have an effect on the firm performance. The empirical findings indicate that size of the board and proportion of non-executive directors have a non-linear relation with firm performance. There is a threshold level on size of the board at 11 and proportion of non-executive directors at 73 % beyond which the performance of the firm starts decreasing. The relationship between executive compensation and firm performance is also found to be non-linear. There is also a saturation level on board compensation, beyond which the performance does not increase. The result suggests that institutional characteristics of emerging economies may support management structures, which are different from those predicted by earlier studies.

JEL classification: G35, J33, C29

Keywords: Firm performance; Corporate Governance; Executive compensation; Spline

specification; Relation between CEO and promoter.

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1. Introduction The importance of corporate board structure and executive compensation as a

mechanism of corporate governance has always been a matter of considerable academic

debate in both theoretical and empirical literature. This issue has also received renewed

attention among the policy makers in both developed and developing countries engaged

in reforming internal corporate governance system, particularly after the East Asian

financial crisis and recent corporate debacles involving giant corporation like Enron and

Worldcom.

The dominant academic view on the issue of board structure, executive

compensation and firm performance essentially draws on the theory of agency costs.

Such costs arise due to the separation of ownership and control in largely held

corporations. In a typical agency theory framework the assumption is that there is a

mismatch between the interest of the shareholders, who are the owners, and that of the

management, who run the corporation, on behalf of the shareholders. In order to better

monitor the managers, shareholders appoint the board of directors. The Board is the link

between shareholders and managers. It is the fiduciary responsibility of the board to

oversee the management.

The issues of board structure, executive compensation and performance of the

firm are discussed in both theoretical and empirical literature. Effect of size and

composition of the board on firm performance is a debatable issue in the literature (see

the survey by Hermalin and Weisbach 2001, and the reference therein). Large boards are

likely to be efficient monitor of the CEO and other executive directors (ED). But there is

evidence that firm performances fall with the increase in board size due to free rider

problems1. The relation between proportion of outside director and firm performance is

ambiguous2. Effect of CEO holding the Chairman position of the board on firm

1 For instance, Fama (1980), Jensen and Meckling (1976) argue board of directors try to avoid the conflicts

with CEO due to peer culture. Therefore, CEO determines all the corporate strategy. Sometime boards are too large to monitor the CEO and supervise the firm performance.

2 For instance, Bhagat and Black (1997) find that there is a positive correlation between firm performance and proportion of outside directors. Rosenstein and Wyatt (1990) find that stock prices of the firm increases on an average by 0.2 percent with the announcement of new additional outside director. Hermalin and Weisbach (1991) do not get any significant contemporaneous correlation among the proportion of outside director and firm performance. Klein (1998), Yermack (1996) find negative

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performance is another debatable issue in the literature. There are evidences that moral

hazard problem increases when CEO becomes the Chairman of the board and therefore it

reduces the performance of the firm (Jensen (1993), Crystal (1991), Pi and Timme

(1993))3. But counter evidences argue that due to information sharing advantage firm can

perform better (Brickley et al. (1997) Main et al. (1995)).

The theoretical literature on pay-performance is mainly based on agency cost. In

setting managerial or board compensation, shareholders have to keep two things under

consideration. The first consideration is the “participation constraint”, i.e., compensation

must be higher than the alternative income available to the CEO from other sources.

Otherwise no efficient CEO or executive director (ED) will join the company. Second

consideration is the “incentive constraint” which takes into account the moral hazard in

managerial effort (Fama (1980), Jensen and Meckling (1976)). The easiest way to

mitigate the moral hazard problem is to align the incentive of the CEO with those of the

shareholders. The issuance of stock and stock option plans is to create high-powered

incentive system to motivate CEO to increase the marginal return of the firm. Suppose α

proportion of the compensation to the CEO and other executive directors is in the form of

variable compensation. If α is very small, effort supply by CEO will be substantially less

than the optimal level. On the other hand if the CEO is mostly paid by the performance-

based criterion (α close to unity) then the CEO bears the entire risk of project failure.

Simultaneously, there are some stylised facts in the empirical literature on pay-

performance: (a) there is a positive relation between CEO compensation and firm

performance4. (b) There is an inverse relationship between pay-performance sensitivity

significant contemporaneous correlation between proportion of independent directors and Tobin’s Q or market value of equity.

3 Jensen (1993) argues when CEO becomes the Chairman of the board since, internal monitoring system

fail to evaluate the performance of the CEO. Where as Crystal (1991) argues that when CEO becomes the Chairperson of the board he/she essentially has the power to influence the entire board and hire or fire the NED from the board.

4 For the argument under (a), see Hall and Liebman (1997); Mehran (1995); Palia (2001); Brunello et al.

(2001) etc. For instance, Hall and Liebman (1997) find that for the firms with $1 million median CEO compensation have annual return of -7% and for the firms with median compensation $5 million the figure is 20.5%. Therefore, there is a difference of about $4 million in compensation for achieving a moderately above-average performance as compared to below-average performance. The difference in

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and market value of the firms5. (c) The firms which have significant and positive

relationship between CEO compensation and firm performance, will give higher returns

to the share holders than those companies which have less sensitive relation between

CEO compensation and firm performance (Mehran 1995). (d) The composition of the

compensation package of the executives is also equally important as the level of

compensation for the firm performance6 and this can be paid directly (via

bonus/commission) or indirectly (via stock option). (e) A common argument against

stock option is that it is easier to hype stock price over a short period than to build a long-

term value. Options are inherently speculative and they can be exercised into cash when

the share price is attractive. Option is just another form of currency and not highly

sensitive to performance as measured by changes in market value of equity 7.

Most of the empirical literature on the pay-performance is based on developed

countries like US, UK, Germany, Italy, Japan etc8. Further, there are some relevant issues

that are not adequately addressed in the literature. Yet, in recent years, the issue of the

effect of board structure and executive compensation on firm performance has been no

less important in developing and emerging economies. Time and again different

corporate governance committees set up to reform extant governance systems in

emerging economies like India, have highlighted the importance of optimally designing

board structures and executive compensation to ameliorate agency problems and

median compensation is $9 million between the firms of 10th percentile performance and 90th percentile performance.

5 For the argument under (b), see Jensen and Murphy (1990b), Schaefer (1998). For instance, Schaefer

(1998) finds pay-performance sensitivity to be approximately inversely related to square root of the size of the firm. A firm in the 25th asset percentile of the sample is predicted to have a salary-plus-bonus sensitivity of 0.000163 and CEO-wealth sensitivity of 0.0628. The model predicts lower sensitivities of 0.000058 and 0.029, respectively, for the firm in the 75th percentile.

6 The average fraction of the executive compensation, which is performance based, say commission, is

quite high and ranging from one-half to five-sixth of the total compensation. See Lewellen and Huntsman (1970), Masson (1971) and Jensen and Murphy (1990a).

7 For the argument under (e), see Jensen and Murphy (1990a); Paul (1992); Sloan (1993) and Harvard

Business Review, Jan 2003. 8 Fama and Jensen (1983), Mehran (1995) and Palia (2001) for US; Brunello et al. (2001) for Italy; Aoki

(1988) for Japan; Dahya et al. (2002) for UK.

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positively influence firm performance. Notwithstanding these, there is very little work on

developing countries per se.

The objective of this paper is to analyse two broad issues in the context of an

emerging economy, India: (1) effects of structure of the board on firm performance and

(2) effects of executive compensation on firm performance. On the first issue, I consider

board size, composition and different identification of the CEO as different attributes of

the board structure. On the second issue, I look at the effects of both the total amount of

executive compensation as well as the composition of it on firm performance.

First, I examine in this paper whether board structure has any effect in improving

the firm performance in India. To be precise, does the firm perform better with the

increase in size of the board or proportion of non-executive directors (NED) in the board

increases? In this context, I specifically examine whether the relationship between board

size and firm performance is non-linear. To examine the non-linear relation I take

second-degree polynomial of both board size and proportion of NED in the regression

equation. From this non-linear equation one can endogenously determine the thresholds

level of the size of the board as well as the proportion of NED in the board beyond which

the relation changes. In the latter part of the paper I replace the quadratic term with spline

specification, piece-wise linear regression to prove the veracity of my findings.

The second question that I address in this paper: Is compensation always an

effective way of motivating CEO and other board members to work in the interest of

shareholders? In other words how this pay-performance relation changes with different

level of compensation or is there any point of saturation in compensation beyond which

the performance of firm does not improve rather it falls? To answer this question,

quadratic function of total compensation of the board is taken followed by spline

specification. I also repeat the analysis for large and small firms to get the separate effect

of the size of the firm and also with the compensation of individual CEO.

As has been argued in the literature, it is the composition of pay that matters more

than the level of pay and further pay should be tied up with performance of the firm. In

practice entire compensation package is not based on the performance of the firm such as

bonus, commission or stock option. There are also some components in the

compensation, which are fixed such as salary, provident fund perquisites and other

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benefits. The third question that I address in this paper is: how the proportions of

different components of compensation to the total compensation of the board affect the

firm performance and is there also any threshold level on the proportion of variable

(performance based) compensation? In the absence of well-developed managerial market

especially in emerging economies, firm needs to pay larger proportion of compensation

in fixed component to motivate the managers. Different committee reports e.g. Kumar

Mangalam Birla (KMB Report, 1999), Confederation of Indian Industry (CII, 1998) in

India, along with US and other developed countries, declare the importance of ceiling the

overall percentage of two broad components of compensation of all the directors, based

on profit (the variable component) and based on time and effort (the fixed component).

However they leave the quantum of ceiling at firm’s own discretion. (refer to KMB

Report, 1999, section 2.47). So, it is important to find out the threshold for the proportion

of variable compensation.

The fourth question of this paper is exclusively based on institutional set-up of the

Indian corporate governance system, which is quite different from the rest of the world.

The relation between CEO and the promoter group9 is another pertinent issue in an

emerging economy i.e., whether CEO can be relative of the promoter group. If CEO is

relative of the promoter group then it becomes immaterial whether he/she is chairman.

This issue essentially emphasises two opposing forces at work: (i) moral hazard, and (ii)

tunneling10 (refer to Bertrand et al., 2002). If CEO is relative of the promoter group the

moral hazard problem is less (non-existent, perhaps) due to loyalty, but there may be

tunnelling incentive. If the CEO is not relative of the promoter then tunneling incentives

are low, but moral hazard problem is high depending whether CEO is holding the

Chairman’s post. Therefore, the fourth question that I have addressed in this paper is:

whether there exists any tunneling effect when CEO is a relative of the promoter. CEO is

also Chairman of the board becomes a relevant issue when CEO is not relative of the

promoter group. Therefore, I have also examined whether CEO expropriates other

9 According to Company Act 1956, Promoter is defined as the person who are instrumental in the

formation of the company or programme pursuant to which the shares were offered to the public and has over-all control of the company;

10 Tunnelling is the way to expropriate minority shareholders by transferring resources from firms where large shareholders of business group have low cash flow rights to firms where they have high cash flow rights. For example, under pricing input price or over pricing the output are some of the ways.

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shareholders more when he/she is not relative of the promoter but holds Chairman

position. To the best of my knowledge this is the first attempt to analyse all these issues

in an integrated manner in the context of an emerging economy, India, which has a large

corporate sector, interesting institutional set up (different from Anglo-Saxon and German

–Japanese models) and has one of the more matured corporate governance system in the

world.

The paper is organised as follows: In Section 2, I describe the institution of

corporate governance in emerging economies especially in India. Empirical models and

methodology and the variables used for the empirical analysis are described in section 3.

Section 4 describes data sources and preliminary data analysis. Section 5 discusses the

empirical findings, and Section 6, concludes.

2. Board Structure and Institution of Corporate Governance in

Emerging Economy, India

The institution of corporations in emerging economies is different from that of the

developed countries. Emerging economies are basically identified by poor corporate

governance system, block shareholdings, large intervention of families in both

management and control, lack of standardised accounting measure and less transparency

in reporting data. Despite of underdeveloped equity market and low investor protection

right emerging economies rely heavily on the banks and other lending institutions. The

different patterns of ownership and management that are followed in different countries

are described in Table 1A.

Most of the firms in India are in the hands of family owned business groups.

Table 1 shows that in the context of management and ownership, India has not only

different from developed countries but also it has distinct features from other developing

countries. In India there are more than 7000 listed firms in National Stock Exchange,

which is more than many developed countries like UK and stock market is also one of the

most ancient stock market in the world.

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Table 1A: Cross country comparison of Ownership and management

Countries Ownership and management

USA Founders hire professional managers. By the time Founder retires he/she and his/her family retain only a marginal ownership, professional managers nearly exercise full control.

Western Europe

Ownership typically retained with family after the founder retires. His/her family either hire a professional managers and control through inter-group cross shareholdings (BMW, FIAT) or run the firm themselves (Peugeot)

Italy

Most of the large and medium firms belong to business group in pyramidal structure. Family, through voting trust and cross shareholdings in allied group, often controls top holding company. Intra-group cross shareholding is less but inter-group cross shareholding is more.

Emerging Economies

Both management and ownership tend to stay with the family when the founder retires. When the professional manager is badly needed, he occasionally marries into the family.

India

Most of the large and medium firms belong to business group in pyramidal structure. Top managers or CEO are often selected from the family member of the promoter group. Intra-group cross shareholding is more than inter-group cross shareholding.

There are also quite similarities in the recommendation of different committee

reports in India with other developed countries like USA, UK etc. Table 1B shows the

recommendation of different committees in USA, UK and India. First column refers to

the name of the committee report and the name of the country in the parenthesis. Second,

third and forth columns refer to the recommendation of the committee on size of the

board, composition of the board and compensation of the directors. For details of the

reports please refer to the each of the committee reports.

From Table 1B, it become clear that all recommendations of different committee

in different countries point out some common features: (1) Size of the board should not

be too large or too small. The optimum board size that largely recommended is 12. (2)

Majority of the board should be comprised of non-executive directors only. The optimum

proportion of non-executive directors that largely recommended is in between two-third

to three-forth. (3) Most of the compensation should be based on the performance of the

firm, in the form of stock options or others. Disclosure of all component of the

compensation package is mandatory recommendation for all the committees.

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Table 1B: Comparison of different committee recommendation on board size, proportion of inside and

outside directors and compensation of the board. Source: Gregory 1999; Cadbury 1992; Birla 1999.

Committee Reports Board Size Proportion of inside and out side

directors Compensation of the board

GM Board Guidelines, 1995

(USA)

The Board in recent years has averaged 15 members. It can be

larger size in order to accommodate the availability of an outstanding

candidate(s). (Guideline 6)

The Board believes that as a matter of policy, there should be a majority of independent Directors

on the GM Board (as defined in By-law 2.12).

To create a direct linkage with corporate performance, the Board

believes that a meaningful portion of a Director’s compensation should

be provided in common stock units.

BRT Statement on Corporate Governance,

1997 (USA)

Boards of directors of most large publicly owned corporations typically

range in size from 8 to 16 individuals. Many [BRT] members suggests that smaller boards are

often more cohesive and work more effectively than larger boards. (p.

10)

It is important for the board of a large, publicly owned corporation to

have a substantial degree of independence from management. Accordingly, a substantial majority

of the directors of such a corporation should be outside (non-

management) directors. (p. 10)

Board compensation should be competitive in view of industry

practices and the extent of burdens placed on board members. Boards

should consider aligning the interests of directors with those of the corporation’s stockholders by

including some form of equity as a portion of each director’s

compensation.

NACD Director Professionalism

Report, 2001 (USA)

Boards should determine the appropriate board size, and

periodically assess overall board composition to ensure the most appropriate and effective board

membership mix. (p. 5)

Inside directors will ordinarily include the CEO and other officers

whose positions or potential for succession make it appropriate, in the judgment of the board, for them to sit on the board. (p.12) Boards should require that independent

directors fill the substantial majority of board seats. (p.9)

A significant ownership stake leads to a stronger alignment of interests

between directors and shareholders. Boards should pay

directors solely in the form of equity and cash with equity representing a substantial portion of the total up to

100 percent; boards should dismantle existing benefit programs and avoid creating new ones. (p.5)

Korn/Ferry Survey, 1999

(USA)

Boards, on average, consist of 11 directors. The boards of larger

companies, on average, consist of 16 directors. (pp. 5, 11) Most

respondents believe that 12 is the most effective board size. (p.11)

Boards should consist of on average, of 3 inside directors

(including the CEO, who frequently serves as chairman) and 9 outside

directors. The largest boards average 3 inside directors and 13

outside directors. (p. 11)

84% compensate with some stock (up from 78%). 65% of directors

believe that a majority of directors’ compensation should be in stock.

(p. 25)

CalPERS Core Principles &

Guidelines, 1998 (USA)

The board should periodically review its own size, and determine

the size that is most effective toward future operations. (Guideline B.3)

A substantial majority of the board consists of directors who are

independent. (CorePrinciple A.1)

Director compensation is a combination of cash and stock in

the company. The stock component is a significant portion of the total

compensation. (Core Principle A.6)

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Table 1B Continued:

Committee Reports Board Size Proportion of inside and out side

directors Compensation of the board

TIAA-CREF Policy Statement,

(USA) Not covered.

The board should be composed of a substantial majority of independent

directors. (p. 2)

Not covered directly, but see p. 6 (The board should request an increase in the authorized number ofcommon

shares only if they are intended for a valid corporate purpose and are not to be used in a manner inconsistent with shareholder interests – for example,

an excessively generous stock option plan.).

AFL-CIO Voting Guidelines

(USA)

The voting fiduciary generally may support a management proposal to

change the number of directors provided a satisfactory explanation justifying the change is given in the

proxy statement. (p.8)

In general, the voting fiduciary should support shareholder

proposals seeking to require that a majority of directors be independent. However, in the context of a change in control, the voting fiduciary should consider that inside directors may be more responsive to the interests of employees and the community in

which they operate. (p.5)

Reasonable compensation should be awarded to [outside directors].

Shareholder evaluation of director compensation is especially important

since directors are responsible for compensating themselves. Thus, full disclosure in the proxy statement of the philosophy and process used in establishing director compensation.

Cadbury Committee

Report, 1992 (UK)

The Board should include non-executive Directors of sufficient

calibre and number for their views to carry significant weight in the

Board’s decisions.

The majority should be independent of the management and free from any business or other relationship, which could materially interfere with

the exercise of their independent judgement, apart from their fees and shareholding. In companies where

the Chairman is also the Chief Executive, it is essential that there

should be a strong and independent element on the Board.

There should be full and clear disclosure of their total emoluments and those of the Chairman and the highest-paid UK Directors, including

pension contributions and stock options. Separate figures should be given for salary and performance-related elements and the basis on which performance is measured

should be explained. Fees of the NED should reflect the time, which they

commit to the company.

Kumar Mangalam Birla Committee

Report, 1999 (India)

Not covered.

In case a company has a non-executive chairman, at least one-third of board should comprise of

independent directors and in case a company has an executive

chairman, at least half of board should be independent.

Compensation package be given to the non-executive independent directors so that these positions become sufficiently financially

attractive to attract talent. All elements of compensation package of all the

directors i.e. salary, benefits, bonuses, stock options, pension etc. should be

disclosed in the annual reports.

In India, CEO11 of the firm can be identified in four categories, which is quite

different from the rest of the studies. The classification is shown in the following

diagram:

11 In India CEO are commonly known as Managing Director (MD)

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Chief Executive Officer

Relative Non Relative

Chairman Not Chairman Chairman Not Chairman

As depicted above the CEOs in India can be broadly classified into two

categories: relative of the promoter group and not relative. Each of these categories can

be divided into two sub categories: Chairman and not Chairman. One important feature of

large Indian firms is: CEO is often relative of the promoter of the company. Out of these

CEOs most of them also hold the position of Chairman. In USA, Germany and other

Developed Countries, CEO can hold the position of Chairman, but in general they are not

the relatives of the promoter group or of other members of the board. In these countries

Board can have representative of the promoter group as Non-Executive Directors, but not

as CEO. If the CEO is relative then in that case they do not list that company. There is

complete separation in management and control. Conventional hypothesis of different

committees (Cadbury in UK, KMB in India) is that CEO should be distinct from the

Chairman. There is a lively debate on this hypothesis also.

3. Empirical Model and Methodology:

Microdynamics and macrodynamics effects cannot be estimated using cross-

sectional data or a single time-series data. Panel data framework can distinguish the

differential effect of firm i.e., effect on firm specific characteristics as well as overtime

effect of external shock on industry. It can reduce the problem of collinearity and enable

us to construct and test more complicated behavioural models that cross-sectional or

time-series data alone cannot do. The power of panel data derives from their theoretical

ability to isolate the effects of specific shocks, treatments or general policies. The typical

assumption for economic variable y that is generated through control experiment and

which have parametric probability distribution function P(y|θ), where θ ∈ R+m may not

be identical for all individual at all point of time. Firm specific or time specific

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unobserved heterogeneity could lead to inconsistent or meaningless estimates of the

variable of interest.

Consider the following simple regression model:

Yit = α* + β’Xit + γ’Zit + εit where, i = 1, 2,….N (1)

t = 1, 2,….T

Xit, Zit are (k1×1) and (k2×1) vectors of exogenous variables. α*, β and γ are (1×1), (k1×1)

and (k2×1) vectors of parameters and εit is independent and identically distributed random

variable with 0 mean and variance σ2 (εit~iid(0, σ2)).

Suppose Zit is unobserved and covariance between Xit and Zit are non-zero. Then

least square regression coefficients of Yit on Xit ( β̂ ), are biased. However, if we have

repeated observation overtime then one can get rid of Zit. For example if Zit = Zi ∀ t then

first difference of individual observation over time gives:

Yit - Yit-1 = β’(Xit - Xit-1) + εit - εit-1 (2)

∇ Yit = β’∇ Xit + Uit where Uit = εit - εit-1 (3)

since, εit~iid(0, σ2) then Uit~iid(0, 2σ2).

Another example, if Zit = Zt ∀ i, then by taking deviation from the mean across

individuals for all the variables at given time also helps to get rid of Zit.

Yit - tY = β’(Xit - tX ) + (Uit - tU ) (4)

Where tY = ∑=

N

iitY

N 1

1 , tX = ∑=

N

iitX

N 1

1 and tε = ∑=

N

iitN 1

1 ε .

In both the cases least square regression provide unbiased estimates. This transformation

would not be possible if (T=1) i.e., cross=sectional data or (i=1) i.e., time-series data.

Mundlak (1978) criticized the random effect model on the ground that it neglects

the correlation that may exist between αi and the explanatory variable Xit. He gives an

example of estimation of production function; output Yit, likely to be affected by

unobservable managerial ability (αi). Firm with more efficient managers tend to produce

more and use more input Xi. In this circumstance αi and Xi are not independent.

Null hypothesis of this paper is that observed board size, composition and

compensation give optimal incentives to improve the performance of the firm. Under this

null hypothesis shareholders or compensation committee choose the compensation of the

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different directors including CEO, which add up to total board compensation to maximise

the firm performance. Firm performance depends on international and domestic

environment as well. This overall environment changes over the years and affects all the

firms in the same industry e.g. depression, oil price shock etc. So, for some years the

performance may fall due to completely exogenous shock to the industry. Therefore, to

control for these factors I used panel framework with time and industry fixed effect. To

estimate the firm performance, I use the following generic non-linear equation:

PERFORMANCEit = α + αt + β1SIZEit + β2(SIZEit)2 + β3PROP_NEDit +

β4(PROP_NEDit)2 + β5(COMPENSATIONit) + β6(COMPENSATIONit)2 +

β7(LSALESit) + β8(ADVINTit) + β9(EXPINTit) + β10(R&DINTIT) +

β11(DEPINTit) + β12(FIRM_AGEit) + β13(LEVERGit) + β14(D_GROUPit) +

∑=

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2g(β15g(Industry_dummyit)) + εit (5)

PERFORMANCEit = f(spline(SIZEit, PROP_NEDit, COMPENSATIONit) + other

economic determinantsit) + εit (6)

where i denotes the firm and t denotes the year. The quadratic specification of

COMPENSATION endogenizes the turning point and allows the pay performance

relation to be different in two segments low and high level of compensation. Later in the

analysis we replace the quadratic specification with a linear spline specification. This

approach has been used in the context of firm value and equity ownership by Morck,

Shleifer and Vishny (1988), McConnell and Servaes (1990) and Sarkar and Sarkar

(2000). I use this methodology to find out the pay performance relation at different level

of compensation (COMPENSATION). The advantage of using spline specifications is, it

permits comparison of pay-performance sensitivity at two relatively low and high level of

compensation. In the quadratic specification, pay-performance sensitivity changes

continuously at each level of compensation segments. Same thing holds for board size

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(SIZE) and proportion of NED (PROP_NED). The quadratic specification allows one to

determine endogenously the spline node12.

Variable Descriptions:

3.1 Performance Variable: Two proxies for firm performance (PERFORMANCE) are

used as dependent variables. The first one is Return on Assets (ROA), an accounting

based measure13 and the second one is Adjusted Tobin’s Q (ADJQ), a market based

measure14 of performance. These two measures are very much well accepted in the

literature. ROA is defined as the ratio of gross profit (i.e., profit before depreciation,

interest and taxes) to book value of total assets. Tobin’s Q is defined as the ratio of

market value of equity and market value debt to replacement costs of firm’s assets. In

India, as some other developing countries, there is no active market for debt. Thus instead

of market value of debt, book value of debt had to be used in the computation in the

computation of Tobin’s Q (Adjusted)15. I used both type of measures in empirical

analysis to check the robustness of the results to alternative measure of performance.

Though some corporate governance practitioners16 criticised the accounting based

measure of performance, but in India 80% of the stocks do not trade for more than six

months (about 200 days) in a year. So, accounting based measure can be more suitable

for these firms. To find out the pay performance elasticity, board size firm performance

or proportion of NED and firm performance elasticity I use log of ROA and log of ADJQ

as proxy for PERFORMANCE.

3.2 Variables of interest

Proxy for Corporate Governance: This paper considers two proxy variables for

corporate governance board size (SIZE) and proportion of NED (PROP_NED).

12 Spline is s simple technique in econometric analysis, which allows piece wise linear relationship between

two variables. More precisely, it allows to vary the slope of particular variables in the regression to be change at certain points, which are known as spline nodes, without affecting the other coefficient in the regression. This technique ensures that the regression line is continuous at different spline nodes, which is unlikely if one use slope dummy instead.

13 Weisbach (1988), Murphy and Zimmerman (1993) etc find accounting measure have predictive content. 14 Morck, Shleifer and Vishny (1988), Martin and McConnell (1991), Palepu (1986), use market-based

measure. 15 Sarkar and Sarkar (2000); Khanna and Palepu (1999) used to measure the performance of Indian firm. 16 Sarkar and Sarkar (2000)

16

SIZE = defined as total number of directors in the board. It includes all executive non-

executive directors.

PROP_NED = defined as fraction of total number of non-executive directors in the board

to total number of directors in the board.

Compensation of the board: The main compensation measure is the total compensation

of the board (TC). Other measures are different components of total Compensation of the

board such as Salary, Commission, Perquisites and other benefits (Perks) and Sitting fees.

In India 1 percent of the net profit is given as commission to the board. Sitting fees are

paid only to the Non-Executive Directors. Salary and Perks are payable only to Executive

Directors. Commission is payable to all the member of the Board if there is sufficient

amount of profit. The proxies for the variable COMPENSATION used in different

regression in this paper are:

TC = defined as total compensation of the board. Measured by sum of all the component

of compensation paid to the board e.g. salary, commission, contribution to provident fund

and other funds, perquisites and other benefits and sitting fees.

PROP_SAL = defined as fraction of compensation of the board paid as salary. This is one

of the major components of fixed compensation.

PROP_COMM = defined as fraction of compensation of the board paid as commission.

Commission is paid if and only if firm earn sufficient amount of profit. This is the only

components of variable compensation or performance based compensation.

PROP_PERKS = defined as fraction of compensation of the board paid as perquisites and

other benefits. This is a fixed compensation component.

PROP_FEES = defined as fraction of compensation of the board paid as sitting fees

payable to non-executive directors. This is also a fixed component of compensation.

Compensation of the CEO: The other compensation measure is compensation (REMU)

of the individual CEO, which is taken from the annual reports in the section of personnel

details of the employee, under the section 217(2A) of the Indian Companies Act (1956) if

available17.

17 If the compensation of the CEO is less than threshold level then company may not report the compensation of the CEO. There are some companies who do not enclosed the personal details of their employee with the annual reports, rather they write ‘if shareholders are interested they (shareholders) should write to company secretary’. So I don’t have data at individual level for these companies.

17

3.3 Economic determinants of firm performance

Performance may be affected by factors other than compensation, such as size of

the firm. I have included log-sales (LSALES) of the firm. “Intensity” of total R & D

expenditure (R&DINT), advertisement expenditure (ADVINT) (as a fraction of total

sales) are included to see the effect of investment on future performance and soft

capital18, which is also known as intangible assets. I also take intensity of export

(EXPINT), depreciation (DEPINT) (as fraction of sales), ratio of long-term debt to equity

(LEVERG) and age of the firm (FIRM_AGE) as other control variables. I included

dummy variables for the firms belong to business group and other industry dummy to

incorporate industry specific fixed effect.

4. Sample selection and data collection

The data on total and different components of the compensation of Board

and individual CEOs, along with other personnel details, are not available in any

database. Therefore, to study the executive pay and firm performance relation I had to

collect the data directly from the primary source i.e., the annual reports of the firms. For

this purpose I gained access to the annual reports of 462 firms from the 1996-97 to 2001-

02 from different sources. There are some missing data for few years due to

unavailability of corresponding annual reports. The data on total compensation along

with its different component is available in the profit and loss section or in the corporate

governance section. Data on compensation of CEO and other personnel details are

available in Annexure B of Directors’ Report under section 217 2(A) Company Act 1956.

The Data on Corporate Governance variables on time series basis are also not available in

any database in India. Thus, I also collected all the information on board of directors

from the list of the name of the directors along with designation in the annual reports.

The detail information about the CEO and other directors are available in the section of

Corporate Governance or Directors’ Report in the annual reports.

The minimum and maximum value of total sales of the firms are Rs.16.49Cr. and

Rs.97258.62Cr. at constant price of 1993-94. So, there is enough variation in the sample

to draw conclusion in general. All the data on firm performance and other economic

18 Palia (2001) uses ‘soft capital’ as advertisement expenditure.

18

indicators such as sales, R&D expenditure, advertisement expenditure, value of debt and

equity, incorporation year of the firms are collected from the database called PROWESS,

brought out by the Centre for Monitoring Indian Economy (CMIE).

4.1 Preliminary Data Analysis:

Prior to regression analysis, lets analyse the data on the basis of descriptive

statistics. Table 2A shows the descriptive statistics of structure of the board i.e., board

size (SIZE) and proportion of NED (PROP_NED). Table 2B shows the mean statistics

for the variables Total Compensation (TC), proportion of salary, commission, perquisites,

sitting fees to TC, ROA and ADJQ for the year 1997-98 to 2001-2002. All the variables

in Table 2B are at constant price of 1993-94. I am not reporting the descriptive statistics

for the year 1996-97 because number of observation for this year is too less (68 only). N

is the number of observation. I can break the entire set of companies under nine

scenario/cases, some of which are very special cases in India. These cases are shown

along the row of the Table 2. First rows show the General cases i.e., taking all firms

together over the years, followed by large firm and small firm cases. If the sales of the

firms are larger than Rs.200 Cr., I consider them as large firms. Then I divide the sample

of firms according to classification of the CEO. Forth to seventh rows shows the cases

where CEO is Relative as well as Chairman, CEO is Relative but not Chairman, CEO is

Chairman but not Relative, and CEO is neither Chairman nor Relative respectively. Last

two rows give the descriptive statistic of the sample, when I divide the sample according

to the number of CEO in the Board. Second last row gives the mean of the aforesaid

variables when the number of CEO more than one.

Table 2A: Descriptive statistics of board size and proportion of non-executive directors in the board under

different cases in India. Note: N is the number of observation.

N SIZE PROP_NED General 1361 10.56 63.79

Large Firms 747 11.50 61.95 Small Firms 614 9.42 66.05

CEO cum CH cum Rel. 347 9.91 56.73 CEO cum CH not Rel. 97 10.21 61.42 CEO cum Rel. not CH 282 11.12 59.99

CEO neither CH nor Rel 635 10.73 69.71 More than one CEO 344 11.14 56.32

Only one CEO 898 10.47 64.85

19

Table 2B: Descriptive Statistics of Total Comp, proportion of salary, commission, perquisites, sitting fees,

and ROA. Note: Total compensation is in Rs. Lakhs at constant price of 1993-94. Rest of the variables are

in percentage form Adj. Tobin’s Q is in ratio.

Year N TC PROP_SAL PROP_COMM PROP_PERKS PROP_FEES ROA ADJQ 1998 190 43.84 53.34 18.27 16.15 6.19 11.82 1.48 1999 289 58.61 54.10 17.46 15.57 6.16 13.81 1.83 2000 385 51.54 52.46 18.13 15.68 7.12 13.76 2.74 2001 316 63.27 51.75 17.02 15.70 7.57 13.66 1.19 G

ener

al

2002 167 74.39 47.46 20.49 16.04 9.66 12.92 1.24 1998 104 58.75 52.52 20.39 15.35 6.92 14.67 1.38 1999 153 89.99 52.04 20.20 15.74 5.54 14.20 1.80 2000 198 75.47 49.73 21.51 15.30 6.37 14.63 2.40 2001 177 91.27 50.12 19.89 16.22 5.81 14.27 1.42 La

rge

Firm

s

2002 110 99.05 48.20 22.39 16.51 5.92 14.07 1.39 1998 86 25.80 54.37 15.74 17.11 5.32 9.24 1.58 1999 136 23.31 56.43 14.43 15.39 6.85 13.44 1.85 2000 187 26.21 55.39 14.51 16.10 7.92 12.91 3.09 2001 139 27.61 53.81 13.32 15.02 9.82 13.00 0.93 Sm

all F

irms

2002 57 26.79 46.04 16.88 15.16 16.93 11.54 1.04 1998 55 47.37 52.70 23.21 15.05 3.64 16.47 1.28 1999 72 56.50 50.52 26.86 14.84 4.12 16.28 1.99 2000 91 70.63 48.87 25.86 12.61 7.17 16.59 4.88 2001 79 82.85 48.30 24.09 13.66 5.58 16.90 1.67

CEO

is R

elat

ive

as w

ell a

s C

hairm

an

2002 44 134.49 48.31 26.20 13.62 6.40 14.54 2.22 1998 44 52.60 49.73 20.68 17.59 5.14 14.66 2.27 1999 58 49.21 55.84 16.18 17.36 3.92 14.03 1.67 2000 79 60.53 55.66 16.35 17.17 4.08 14.24 2.84 2001 67 90.71 51.61 19.78 16.38 4.84 15.24 0.99

CEO

is R

elat

ive

but n

ot

Cha

irman

2002 34 73.70 39.08 27.08 18.79 8.43 12.67 0.86 1998 11 27.37 58.84 12.13 16.66 2.99 13.87 1.13 1999 19 30.04 63.67 9.37 11.94 4.37 16.25 2.97 2000 28 40.78 63.47 9.27 16.79 3.82 7.04 5.93 2001 25 45.06 63.33 9.58 18.18 2.94 3.53 1.04 C

EO is

C

hairm

an b

ut

not R

elat

ive

2002 13 49.82 60.73 10.06 18.63 3.04 12.47 0.78 1998 80 38.86 54.95 14.51 16.00 8.94 14.64 1.24 1999 140 67.47 53.91 14.46 15.71 8.36 13.15 1.74 2000 187 40.07 51.21 16.47 16.40 8.86 13.31 1.60 2001 145 43.06 51.67 13.18 16.06 10.64 12.76 1.21

CEO

is n

eith

er

Cha

irman

nor

re

lativ

e

2002 76 44.11 48.62 15.74 15.77 13.11 13.13 1.68 1998 55 49.84 53.98 16.68 17.58 3.60 14.95 1.19 1999 72 55.24 56.37 14.56 16.57 4.52 13.38 1.34 2000 91 82.77 53.31 16.82 17.68 5.32 14.29 2.37 2001 81 104.31 50.97 17.09 17.43 4.90 14.41 1.25

Mor

e th

an o

ne

CEO

2002 43 114.76 48.69 19.08 18.02 8.00 12.02 1.63 1998 122 38.53 53.38 19.50 16.60 5.54 15.56 1.70 1999 199 40.90 54.96 19.25 15.55 4.55 14.77 2.12 2000 260 41.92 53.52 19.53 15.66 4.97 14.08 3.44 2001 207 48.48 52.90 17.72 15.39 6.94 13.30 1.36

Onl

y O

ne C

EO

2002 108 64.77 47.40 22.80 15.42 7.77 14.16 1.68

20

The last row shows the case where CEO is only one19.

Table 2A shows in India average board size is approximately 11 and out of that

two-third of the board is occupied by NED. Large firms have larger board size but lesser

proportion of NED. Board size as well as proportion of NED in the board is lowest when

CEO is relative of the promoter group and Chairman of the board.

Most of the board want their CEO and other ED to be in the top half of the

executive peer group. So, they increase the total compensation of the board along with

proportion of perquisites and sitting fees every year, shown in Table 2B. They believe

that it makes the company look strong even if it is a bad year for the firm. Average TC

and ROA are much higher for the large firms than the small firms. Overall average

proportion of salary is 52%; commission is 18%; perquisites is 15%; sitting fees is 7%

and rest i.e., provident fund is 8%.

Table 2B shows that proportion of Salary (commission) is highest, 63% (lowest,

9%) of TC for the firm where CEO is Chairman but not relative. Vis-à-vis when CEO is

relative then proportion of salary is less and commission is high. The ROA of the firms is

higher when CEO is relative of the promoter group. This indicates that when CEO is

relative of the promoter group moral hazard problem is quite less. ADJQ is lower if the

CEO is from professional. Intuition may be, to make their job secure and to please the

promoter group, professional CEO decrease the distributed profit and increase the

reserves. As a result market value of equity becomes lower. If the CEO is not relative of

the promoter group the moral hazard problem is higher and it become highest when CEO

holds the Chairman’s position. Table 2B shows that ROA is lowest when CEO is

Chairman but not relative among the four classification of CEOs.

Free riding problem increases with the increases in number of CEO in the firm.

Table 2B shows that not only TC is higher but also proportion of commission (perks) is

lower, 17% (higher, 18%) if the number of CEO in the firm is more than. If the firm has

only one CEO then both ROA and ADJQ is higher. This indicates that increasing the

number of CEO in the firm actually does not help in managing the firm better; actually it

increases the cost of asymmetric information between the CEOs.

19 I consider only those persons as CEO who has designation Managing Director (MD) or Joint Managing Directors (JMD). Some of these MD or JMD also hold the Chairman or Vice-Chairman post. In India CEO are commonly known as Managing Director. Some of the firm in my sample have five or six CEOs.

21

5. Empirical Findings:

After controlling for all possible firm specific characteristics as discussed above I

allowed the intercept to be different with the firms belong to different industry, to capture

the industry specific heterogeneity. All the equations are estimated in unbalanced panel

framework by the ordinary least square (OLS), with fixed time and industry effect, after

checking for the presence of influential observation and hetroscedasticity. In latter part of

the regression analysis I use linear spline specification20, after determining the spline

node from the quadratic equation, to vary the slope coefficient for some variables for

specific range of value of the variables. I use the specification test suggested by White

(1980) but did not find any hetroscedasticity in the model. Consistency of the estimates

depends on the distribution of the error. Therefore, after every regression I took out the

residual and did the white noise test. The test found that the residual is a pure random

walk without drift and my estimator is unbiased and consistent (not reported in the paper

and can be sent on request).

5.1 Relation Between Corporate Governance and Firm Performance Table 3 shows performance of the firm, in terms of ROA, increases with the

increase in size of the board, but at a decreasing rate for all firms’ case (Panel A). As the

number of board members increases monitoring advantage increases but simultaneously

free riding problem also increases. Initially monitoring advantage is more than free riding

disadvantage. At the threshold level (11 board member) these two opposing forces are

equal and after that free riding disadvantage wins over monitoring advantage. Similarly

as proportion of NED increases, firms start performing better. But NED are not full-time

employees of the firm and they cannot take day-to-day decisions.

20 In the quadratic relation one can have only one knot say at X = A. Then there will be two piece-wise linear relationship between Y and X and therefore two spline variables X1 and X2. X1 and X2 are defined as follows: Spline1 = X1 = X if X < A; = A otherwise. Spline2 = X2 = 0 if X ≤ A; = X – A otherwise. The Piece-wise linear relation can be obtained by running a linear regression with two spline variables, X1 and X2.

22

Table 3:

Regression results of ROA and ADJQ on second-degree polynomial of TC, board size, proportion of NED

and other economic determinants for all, large and small firms.

In Panel A, I consider the set of all the firms for the year 1997 to 2002. Panel B considers the set of large

firms only. If the annual sale of a firm is more than Rs.200 Cr., then I consider that firm as large firm. Panel

C considers the set of small firms only. Each of the panel shows two regression results. Dependent variable

of the first regression result is ROA, which is in percentage form. Dependent variable of the second

regression is ADJQ, which is a ratio. TC is in Rs. Crore. Proportion of NED is also a ratio. All the

regressions include year and industry fixed effects. P-value of the regression is reported in the parenthesis. I

have also tested for hetroscedasticity. All the regressions are free from hetroscedasticity.

Panel A Panel B Panel C All Firms Large firms Small firms Variables Predicted

Sign ROA ADJQ ROA ADJQ ROA ADJQ

INTERCEPT ? -8.411 (0.258)

2.873 (0.466)

16.577*** (<.0001)

-4.635 (0.263)

-57.526*** (<.0001)

9.801 (0.120)

SIZE + 1.125*** (0.010)

-0.408 (0.175)

0.366 (0.289)

0.384 (0.304)

0.568 (0.673)

-2.110** (0.004)

(SIZE)2 - -0.049*** (0.006)

0.011 (0.397)

-0.020 (0.131)

-0.021 (0.167)

-0.016 (0.813)

0.090** (0.012)

PROP_NED + 54.416*** (<.0001)

-0.497 (0.929)

-0.114 (0.988)

0.974 (0.866)

206.991*** (<.0001)

-7.793 (0.584)

(PROP_NED)2 - -37.148*** (<.0001)

-0.313 (0.945)

3.941 (0.544)

-2.191 (0.649)

-148.337*** (<.0001)

6.456 (0.565)

TC + 3.438*** (<.0001)

1.064*** (<.0001)

3.244*** (<.0001)

0.913*** (0.002)

14.360*** (<.0001)

2.813 (0.124)

(TC)2 - -0.147*** (<.0001)

-0.053*** (0.005)

-0.137*** (<.0001)

-0.047*** (0.008)

-3.052** (0.027)

-0.673 (0.280)

LSALES + 0.364 (0.319)

0.343* (0.075)

-0.095 (0.803)

0.501* (0.086)

-0.172 (0.906)

0.483 (0.490)

ADVINT + 56.451*** (<.0001)

15.418* (0.061)

42.170*** (<.0001)

12.694 (0.171)

85.104** (0.023)

25.906 (0.172)

EXPINT + 5.610*** (<.0001)

8.378*** (<.0001)

4.800*** (0.002)

12.846*** (<.0001)

7.287*** (<.0001)

6.031*** (<.0001)

R&DINT + 26.259 (0.471)

-19.387 (0.308)

-30.119 (0.256)

-24.811 (0.206)

240.733*** (0.007)

-18.189 (0.700)

DEPINT - -1.557*** (<.0001)

-0.120 (0.982)

-8.331 (0.384)

-11.244 (0.112)

-2.370** (0.020)

6.367 (0.474)

FIRM_AGE ? -0.025* (0.086)

0.001 (0.894)

-0.021* (0.078)

0.005 (0.560)

-0.043 (0.161)

-0.007 (0.636)

LEVERG ? 0.037 (0.811)

-0.080 (0.454)

-0.047 (0.631)

0.001 (0.995)

1.241* (0.061)

-0.582* (0.089)

D_GROUP ? -3.654*** (<.0001)

-0.634 (0.149)

-4.930*** (<.0001)

-0.184 (0.776)

-2.296 (0.117)

-0.638 (0.360)

R-Square 0.18 0.22 0.35 0.26 0.25 0.23 Adj R-Sq 0.16 0.19 0.32 0.22 0.20 0.17 F 8.33 9.43 11.63 7.15 5.30 4.14 N 1407 1291 789 753 617 537 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

NED generally meet at the general board meeting, which are held once in two or three

months. Executive directors (ED) and CEO are responsible for the day-to-day

management of the firm. As the proportion of executive directors decreases, managers

start playing on their own and agency costs aggravate. Therefore, after certain threshold

23

point (73% for all firms and 70% for small firms) performance of the firm in terms of

ROA starts falling. One more reason is, due to shortage of time and lack of incentives

NED avoid conflicts with the CEO. But executive directors do better peer monitoring for

their own common interest, firm performance. So, there needs to be a balance between

proportion of NED and ED. Executive directors should fill one quarter of the board

Table 4:

Regression result of firm performance on linear Spline specification of board size, Proportion of NED in

the board and TC.

Panels A and B of this table shows the regression results of ROA and ADJQ respectively. First column in

each panel gives the estimated coefficient of the regression and second column gives the P value of the

coefficient. ROA is measured in percentage form and ADJQ is measured in ratio form. The exogenous

variables of interest are Spline variables SIZE1, SIZE2, PROP_NED1, PROP_NED2, TC1 (in Rs. CR.) and

TC2 (in Rs. Cr.). TC1 is the first spline variable with respect to TC. TC1 = TC if TC<10; =11 if TC≥10.

The Second spline variable with respect to TC is TC2. TC2 = 0 if TC ≤10; = TC-10 if TC>10. Similarly

SIZE1, SIZE2 are the spline variables for SIZE and PROP_NED1, PROP_NED2 are the spline variables

for PROP_NED. Other than the control variables like log of sales, advertisement intensity, export intensity,

R&D intensity, depreciation intensity, age of the firm, leverage and group dummy, industry and time fixed

effect are also included in the regression.

Panel A Panel B ROA ADJQ Variables Estimates P-value Estimates P-value INTERCEPT 4.558 0.284 0.390 0.858 SIZE1 0.619*** 0.003 -0.176 0.126 SIZE2

-0.498*** 0.008 -0.122 0.229 PROP_NED1 13.433*** <.0001 -1.825 0.211 PROP_NED2 -5.403 0.407 1.943 0.594 TC1 2.557*** <.0001 0.745*** 0.001 TC2 -1.899* 0.068 -0.727 0.114 LSALES 0.440 0.228 0.366* 0.056 ADVINT 61.898*** <.0001 16.162** 0.047 EXPINT 6.052*** <.0001 8.472*** <.0001 R&DINT 38.638 0.289 -16.329 0.388 DEPINT -1.705*** <.0001 -0.428 0.937 FIRM_AGE -0.022 0.137 0.001 0.881 LEVERG 0.038 0.806 -0.077 0.472 D_GROUP -3.975*** <.0001 -0.685 0.119 R-Square 0.17 0.22 Adj R-Sq 0.15 0.19 F 8.03 9.62 N 1407 1291 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

24

The Spline specification in Table 4 proves the veracity of the finding in Table 3.

In Table 4, for the board size less than 11, ROA increases 0.62% with the increase in one

member in the board (SIZE1). But as the board size exceeds 11 ROA decrease with the

increase in the board size (SIZE2). Similarly if the proportion of NED is less than 73%

then ROA increases by 13.4% with the increase in proportion of NED (PROP_NED1).

After crossing the threshold level ROA does not increase with proportion of NED

(PROP_NED2). Results in Table 4 confirm that the size or proportion of NED in the

board do not always help to improve the performance of the firm.

5.2. Relation Between Board Compensation and Firm Performance Table 3 shows that for all the cases i.e., all firms, large firms and small firms

performance of the firm improves with the increase in total compensation (TC) but at a

decreasing rate. TC has positive effect on both the measure of performance (ROA and

ADJQ) but square of TC has negative significant effect. There is an inverted-U shape

relation between firm performance and TC. There is a threshold level on TC at Rs.10 Cr.

for all firms, Rs.12 Cr. for large firm and Rs.2.4 Cr. for small firms beyond which the

performance of the firm actually start falling. The interpretation is, as the compensation

of the board increases, at the lower level of compensation, efficiency of the board

increases. It motivates the board to work hard. But as the compensation further increases,

the gain in marginal utility due to increase in compensation falls. As the TC cross the

threshold level, TC fails to motivate the board any more to work hard in favour of the

firms. For Rs.1 Cr. increases in TC net increase in ROA for the large firms is 3.1 percent

and for the small firms is 11.3 percent. Smaller firms have larger scope for improvement

with the increase in TC.

In the linear spline specification in Table 4, for the compensation less than Rs.10

Cr. performance of the firm increases, (ROA by 2.6 % and ADJQ by 74%) as the TC

(TC1) increases. But as the TC becomes more than Rs.10 Cr., ROA of the firm decreases

by 1.9% with the increase in TC (TC2). This substantiates the assertion that

compensation does not always motivate the directors. In other words, only at lower levels

of compensation, increase in compensation motivates the directors to work hard in favour

of firm and shareholders.

25

5.3 Elasticity of Firm Performance With Respect to Board Size,

Proportion of NED and Board Compensation The regression results of log of ROA and ADJQ on log of the interest variables

are reported in Table 5. Table 5:

Estimation of elasticity of firm performance with respect to board size, proportion of NED and board

compensation.

Dependent variables are log of ROA and log of ADJQ. A set of explanatory variables is log of board size,

fraction of total number of NED to total board size, TC and sales. Other explanatory variables are

Advertisement intensity, export intensity, R&D expenditure intensity, age of the firm, leverage and group

dummy. All the equations are estimated with fixed industry and time effect. P-values are reported in the

parenthesis. Panels A, B and C give the regression results for all firms, large firms and small firms.

Panel A Panel B Panel C All Firms Large firms Small firms Variables

LROA LADJQ LROA LADJQ LROA LADJQ

INTERCEPT 3.742*** (<.0001)

0.173 (0.679)

3.754*** (<.0001)

0.367 (0.443)

3.854*** (<.0001)

0.629 (0.222)

LSIZE -0.220*** (<.0001)

-0.165** (0.047)

-0.271*** (<.0001)

-0.108 (0.317)

-0.184* (0.080)

-0.321** (0.016)

LPROP_NED 0.187*** (<.0001)

0.013 (0.841)

0.137** (0.017)

-0.041 (0.604)

0.279*** (0.005)

-0.001 (0.996)

LTC 0.138*** (<.0001)

0.152*** (<.0001)

0.108*** (<.0001)

0.131*** (<.0001)

0.184*** (<.0001)

0.202*** (<.0001)

LSALES 0.004 (0.803)

0.037 (0.115)

0.027 (0.308)

0.009 (0.809)

-0.036 (0.533)

0.073 (0.337)

ADVINT 3.366*** (<.0001)

7.758*** (<.0001)

2.462*** (0.006)

6.892*** (<.0001)

3.063** (0.039)

7.070*** (<.0001)

EXPINT 0.214 (0.002)

1.137*** (<.0001)

0.201* (0.079)

1.705*** (<.0001)

0.183** (0.045)

0.829*** (<.0001)

R&DINT 1.869 (0.284)

7.022*** (0.004)

-1.683 (0.398)

8.484*** (0.002)

10.131*** (0.003)

-4.004 (0.434)

DEPINT -0.094*** (<.0001)

2.226*** (<.0001)

-0.573 (0.455)

0.504 (0.600)

-0.086** (0.033)

3.484*** (<.0001)

FIRM_AGE -0.002** (0.030)

0.000 (0.963)

-0.002** (0.043)

0.001 (0.369)

-0.001 (0.348)

-0.002 (0.150)

LEVERG -0.014* (0.086)

-0.014 (0.293)

-0.015* (0.058)

-0.007 (0.642)

-0.023 (0.453)

-0.063* (0.090)

D_GROUP -0.145*** (<.0001)

-0.276*** (<.0001)

-0.249*** (<.0001)

-0.316*** (<.0001)

-0.051 (0.381)

-0.262*** (<.0001)

R-Square 0.23 0.42 0.28 0.46 0.25 0.45 Adj R-Sq 0.21 0.40 0.25 0.44 0.20 0.41 F 11.27 26.31 9.08 19.28 5.39 12.21 N 1353 1280 771 748 581 531 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

In Table 5, for all firms’ case elasticity of ROA and ADJQ with respect to board

size is -0.22 and -0.16 respectively. For the large firms case elasticity of ROA and ADJQ

with respect to board size is -0.27 and inelastic respectively. For the small firms case

26

elasticity of ROA and ADJQ with respect to board size is -0.18 and -0.32 respectively.

Elasticity of ROA with respect to proportion of NED for all firms, large firms and small

firms are 0.19, 0.14 and 0.28 respectively. Elasticities of ADJQ with respect to proportion

of NED for all the cases are inelastic. The result can be interpreted as, for the smaller

firms NED do better monitoring job than for the large firms. Elasticity of ROA with

respect to proportion of non-executive directors in the board is inversely proportional to

the size of the firm.

Percentage increase in ROA and ADJQ due to 1 percent increase in TC i.e.,

elasticity for all firms’ case is 0.14 and 0.15 respectively. For the large firms these

elasticities are 0.11 and 0.13 respectively, where as for the small firms 0.18 and 0.20

respectively. My findings support the view of Jensen and Murphy (1990b) that there is an

inverse relation between pay and performance and size of the firm.

5.4. Relation Between Different Components of TC with Performance of

the Firm From Table 2B it became clear that average proportion of variable compensation

in India is much lower than that of the developed countries. Till 2002 in India, reporting

of Employee Stock Option Plan (ESOP) was not mandatory for the firm. Since my data

set covers only upto 2002, there is no data on stock option. Most of the annual reports

give four broad components of compensation salary, commission cum other performance

incentives, perquisites cum other benefits and sitting fees. In this section I find out the

individual effect of different broad components of compensation on the firm performance

in India. Table 6 shows proportion of all the fixed component of TC e.g. salary and perks

have negative significant effect on the firm performance especially on ROA.

Interpretation is, as the proportion of fixed components of the compensation increases,

moral hazard problem increases and as a consequence performance of the firm decreases.

For 1 percent increases in proportion of salary and perks, ROA decrease by 15 and 21

percent respectively. But as the proportion of variable compensation, commission,

increases firm performance also improves but at a decreasing rate. Since, proportion of

commission has positive significant effect on ROA but square of it has negative

significant effect on ROA.

27

Table 6:

Regression results of ROA and ADJQ on proportion of four different components of compensation to TC.

In all the panels, I consider the set of all the firms for the year 1997 to 2002. In panels A, B, C and D I

consider proportion of salary, commission, perquisites and sitting fees to total compensation and theirs

square respectively as the interest variables. Each of the panel shows two regression results. Dependent

variable of the first regression result is ROA, which is in percentage form. Dependent variable of the

second regression is ADJQ, which is in ratio. TC is in Rs. Crore. Proportion of NED is also a ratio. All the

regressions include control variables, which I have discussed earlier, year and industry fixed effects. P-

value of the regression is reported in the parenthesis.

Panel A Panel B Panel C Panel D Variables ROA ADJQ ROA ADJQ ROA ADJQ ROA ADJQ

INTERCEPT -11.145 (0.137)

-0.543 (0.881)

-15.184**(0.040)

-0.066 (0.985)

-15.071** (0.046)

0.114 (0.975)

6.402 (0.205)

-0.228 (0.950)

SIZE 1.609*** (<.0001)

0.045 (0.869)

1.363*** (0.002)

0.011 (0.969)

1.614*** (<.0001)

0.023 (0.936)

0.904*** (0.003)

-0.010 (0.972)

(SIZE)2 -0.066*** (<.0001)

-0.006 (0.601)

-0.058*** (0.002)

-0.005 (0.669)

-0.064*** (<.0001)

-0.005 (0.672)

-0.039*** (0.002)

-0.005 (0.688)

PROP_NED 60.907*** (<.0001)

2.472 (0.627)

47.751***(<.0001)

2.194 (0.672)

66.596*** (<.0001)

2.325 (0.657)

12.527* (0.095)

1.712 (0.746)

(PROP_NED)2 -44.944*** (<.0001)

-3.559 (0.392)

-33.083***(<.0001)

-3.437 (0.417)

-48.048*** (<.0001)

-3.546 (0.409)

-8.856 (0.145)

-2.916 (0.499)

PROP_SAL -15.163*** (0.003)

-0.256 (0.923)

(PROP_NED)2 9.132** (0.058)

0.866 (0.722)

PROP_COMM 16.590***(<.0001)

-1.551 (0.402)

(PROP_ COMM)2 -11.097* (0.051)

2.526 (0.351)

PROP_PERK -21.447***

(0.002) -3.175 (0.319)

(PROP_ PERK)2 24.935* (0.084)

3.328 (0.623)

PROP_FEES -3.293 (0.464)

-2.685 (0.407)

(PROP_ FEES)2 3.113

(0.521) 2.185

(0.563)

LSALES 1.041*** (0.003)

0.492*** (0.003)

0.990*** (0.004)

0.492*** (0.003)

1.148*** (0.001)

0.491*** (0.004)

0.788*** (<.0001)

0.560*** (<.0001)

ADVINT 76.079*** (<.0001)

20.783*** (0.005)

66.667***(<.0001)

21.687*** (0.004)

80.973*** (<.0001)

20.260*** (0.007)

70.321*** (<.0001)

19.021** (0.011)

EXPINT 5.621*** (<.0001)

8.096*** (<.0001)

4.954*** (<.0001)

8.121*** (<.0001)

5.294*** (<.0001)

8.001*** (<.0001)

4.270*** (<.0001)

7.923*** (<.0001)

R&DINT 59.532 (0.109)

1.941 (0.911)

46.462 (0.209)

-1.679 (0.924)

66.983* (0.075)

-1.180 (0.947)

87.317*** (<.0001)

2.306 (0.897)

DEPINT -2.068*** (<.0001)

-2.408 (0.624)

-1.812*** (<.0001)

-2.069 (0.677)

-2.194*** (<.0001)

-1.699 (0.748)

-23.439*** (0.002)

-1.732 (0.742)

FIRM_AGE -0.029** (0.045)

-0.003 (0.698)

-0.027* (0.066)

-0.002 (0.797)

-0.034** (0.026)

-0.002 (0.736)

-0.039*** (<.0001)

-0.002 (0.756)

LEVERG 0.006 (0.968)

-0.085 (0.384)

0.055 (0.721)

-0.087 (0.373)

0.015 (0.927)

-0.075 (0.446)

-0.110 (0.306)

-0.109 (0.302)

D_GROUP -4.369*** (<.0001)

-1.006** (0.013)

-4.131*** (<.0001)

-1.016** (0.013)

-4.223*** (<.0001)

-1.050** (0.011)

-3.527*** (<.0001)

-0.946** (0.024)

R-Square 0.17 0.22 0.19 0.22 0.18 0.22 0.22 0.22 Adj R-Sq 0.15 0.20 0.17 0.20 0.15 0.20 0.20 0.19 F 7.60 9.40 8.56 9.49 7.54 9.15 10.04 8.91 N 1370 1262 1356 1249 1327 1223 1331 1234 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

28

For 1 percent increase in proportion of commission net increase in ROA is 5.5

percent. But ROA does not increase monotonically with the increase in proportion of

commission. There is a critical level of proportion of commission at 75 percent of TC.

Beyond this level ROA starts falling with the increases in proportion of commission.

Intuition can be as follows: as the proportion of commission in TC increases the risk of

the compensation of the directors also increases. As we assume that managers are risk

averse so, they start taking all those projects such that a certain amount of personal

benefit is ensured, and that can in turn reduce the ROA of the firms. Sitting fees have no

significant effect on firm performance. Structure of the compensation has no significant

effect on the market value of equity i.e., ADJQ. This supports the view of Jensen (1990a),

Paul (1992), and Sloan (1993).

5.5. Relation Between ROA and Compensation of the CEO

In this section I find out the effect of compensation of individual CEO on the

performance of the firm. In Indian Corporate sector there are three types of firms say A,

B and C. Type A are those firms who report the compensation of the all the employee in

the annual reports, whose compensation are above the threshold level21, along with other

personnel details under section 217(2A), the Indian Company Act. 1956. The

compensation of the CEO(s) is available for this set of firms. Type B firms are those who

have no employee who have compensation more than the threshold level. Type C firms

do not supply the section of personnel details, in the annual reports. Instead they write if

any shareholder is interested about this information then latter should write to the

Company Secretary. For this type of firm, no information is available about the gross

compensation of the CEO and other personnel details. Therefore, I add two more dummy

variables in equation 5 to capture the differential characteristics of these firms. I take type

A firm as reference point and dummy D_REMU99 = 1, if firm is type B; = 0, otherwise.

Other dummy is D_NOREMU = 1, if firm is type C; = 0, otherwise.

21 Threshold level is defined like this: for the year 1997 and 1998 it was Rs.300000 per annum, for 1999 and 2000 it was Rs.600000 per annum and for 2001 and 2002 it was 1200000 per annum. According to SEBI guidelines if the employees compensation is less than the threshold level then firm may not report the personal details of that employee in the Annual Report.

29

Table 7:

Regression results of ROA and ADJQ on gross compensation of the CEO(s) for all firms (general case),

large and small firms. Panel A shows the regression results for the sample all firms. Panel B and C show the regression results for

the sample of large firms and small firms respectively. Two columns of each of the panel give the result of

regression of ROA and ADJQ on second-degree polynomial of compensation of the CEO and other

variables discussed in equation 5. Two more variables are added to equation 5, D_NOREMU and

D_REMU99. All the regression includes year and industry fixed effects. P-value of the regression is

reported in the parenthesis.

Panel A Panel B Panel C All Firms Large firms Small firms Variables

ROA ADJQ ROA ADJQ ROA ADJQ

INTERCEPT -9.276 (0.210)

1.647 (0.644)

12.845** (0.014)

-5.697 (0.171)

-64.269*** (<.0001)

12.215 (0.032)

SIZE 1.482*** (<.0001)

-0.048 (0.861)

0.623* (0.077)

0.470 (0.214)

2.131 (0.148)

-1.039* (0.077)

(SIZE)2 -0.059*** (<.0001)

-0.002 (0.829)

-0.027** (0.044)

-0.023 (0.122)

-0.082 (0.260)

0.043 (0.139)

PROP_NED 49.210*** (<.0001)

-1.598 (0.753)

-5.164 (0.523)

0.013 (0.998)

204.186*** (<.0001)

-9.089 (0.440)

(PROP_NED)2 -35.709*** (<.0001)

-0.405 (0.922)

6.945 (0.302)

-1.656 (0.737)

-153.355*** (<.0001)

5.043 (0.584)

REMU 7.708*** (<.0001)

3.233*** (<.0001)

8.976*** (<.0001)

2.569** (0.020)

18.526** (0.031)

9.692*** (0.003)

(REMU)2 -1.460** (0.032)

-0.750** (0.016)

-1.749*** (<.0001)

-0.603* (0.071)

-6.792 (0.249)

-5.281** (0.015)

D_NOREMU 1.644 (0.134)

0.694 (0.176)

0.481 (0.597)

0.035 (0.959)

7.944*** (<.0001)

1.991** (0.021)

D_REMU99 -4.973*** (<.0001)

-0.229 (0.677)

-0.415 (0.680)

0.119 (0.873)

-7.036*** (0.004)

0.052 (0.956)

LSALES 0.734** (0.040)

0.379** (0.027)

0.419 (0.275)

0.608** (0.037)

0.144 (0.921)

-0.326 (0.562)

ADVINT 69.538*** (<.0001)

17.991** (0.015)

62.773*** (<.0001)

19.022** (0.042)

104.672*** (0.005)

24.087 (0.108)

EXPINT 5.385*** (<.0001)

7.853*** (<.0001)

5.918*** (<.0001)

13.080*** (<.0001)

6.730*** (0.003)

5.294*** (<.0001)

R&DINT 38.056 (0.306)

-12.299 (0.487)

-35.631 (0.209)

-24.439 (0.239)

272.278*** (0.002)

6.330 (0.865)

DEPINT -1.887*** (<.0001)

-1.194 (0.806)

-7.838 (0.421)

-10.796 (0.131)

-2.864*** (0.005)

2.913 (0.687)

FIRM_AGE -0.024 (0.101)

0.001 (0.916)

-0.020 (0.103)

0.005 (0.617)

-0.040 (0.199)

-0.006 (0.628)

LEVERG -0.050 (0.746)

-0.088 (0.366)

-0.068 (0.503)

-0.005 (0.964)

1.178* (0.071)

-0.463 (0.087)

D_GROUP -3.810*** (<.0001)

-0.902** (0.024)

-5.313*** (<.0001)

-0.297 (0.647)

-2.357 (0.109)

-0.873 (0.122)

R-Square 0.19 0.22 0.33 0.26 0.27 0.25 Adj R-Sq 0.17 0.20 0.30 0.22 0.22 0.19 F 8.24 9.13 10.09 6.65 5.34 4.28 N 1391 1281 785 749 605 531 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

30

Firm performance increases with the increase in the compensation of the CEO but

at a decreasing rate. Compensation of the CEO has a positive and significant effect on the

firm performance, but the square of the compensation of the CEO has negative significant

effect on the firm performance. Intuition is, as the income of the CEO increases leisure

become luxury goods for the CEO and they start consume more of leisure. As the leisure

of the CEO increases, effort of the CEO falls and as a consequence the performance of

the firm also falls. For Rs.1 Cr. increase in compensation of the CEO the net increase in

ROA and ADJQ for all the firms are 6.3 and 250 percent respectively whereas, for the

large firm the net increase in ROA and ADJQ are 7.2 and 190 percent respectively.

Comparing with Table 3, the effect of the increase in compensation of CEO on firm

performance is more than that of the total compensation of the board. Combining the

results from Table 3 and 7, I find that CEO(s) are more productive for the firm than the

entire board. Effort made by the CEO is more valuable for the firm than any other

directors (executive or non-executive) in the board. Performance of the firm increases

more if the compensation of the CEO increases by Rs.1 Cr. rather than if these Rupees

are divided among all the board members. The relation between compensation of the

CEO and firm performance is an inverted-U shape. My findings support the view of Palia

(2001). There is also a threshold point at Rs.2.56 Cr. in the relation between CEO

compensation and ROA, beyond which the ROA of the firm start falling. Similarly for

the relation between CEO compensation and Adjusted Tobin’s Q (ADJQ), the threshold

point is at Rs.2.15 Cr. For the small firm there is monotonic positive relation between

ROA and compensation of the CEO. The threshold point in the relation between CEO

compensation and Adjusted Tobin’s Q for the small firms is at Rs.0.9 Cr. Coefficient of

the dummy D_REMU99 is negative significant effect on ROA for all firms case and

small firms case. This shows the fact that the firms that pay its CEO less than threshold

level, specified by SEBI guidelines, perform worst. Dummy D_NOREMU has positive

significant effect on firm performance for the small firms case only. Therefore, for

improving the firm performance compensation of the CEO has very significant positive

contribution as the size of the board and proportion of NED in the board, but the

relationship is not strictly monotonic.

31

5.6. Variation of pay-performance elasticity with different identity of

CEO:

In India majority of the CEO are selected from the relative of the promoter group

and they dictate the entire board. Some of these CEO(s) are also the Chairman of the

board. In developed countries CEO are selected from professional group to avoid

tunnelling incentives. Most of the committee report22 over the world recommended that

Chairman of the Board should not be CEO of the company due to moral hazard problem.

In this section I examine how far this is true in India and how exactly the pay-

performance elasticity changes with different identity of CEO in the board.

Table 8 shows elasticity of ROA with respect to proportion of NED is positive

and significant only for the sample of firms where CEO(s) are relative of the promoter

group as well as Chairman of the board. This implies that non-executive directors has

some scope to improve the firm performance only when CEO(s) are relative as well as

Chairman. In this case elasticity of firm performance i.e., ROA and ADJQ with respect to

pay are 0.17 and 0.19 respectively. If the CEO(s) are relative of the promoter but not

Chairman of the board then elasticity of firm performance i.e., ROA and ADJQ is highest

with respect to the pay of the Board, 0.22 and 0.28 respectively. For the firms who’s CEO

is Chairman but not relative the pay-performance relation is inelastic when the

performance is measured in terms of ROA. If CEO is outside professional person (Panel

D) i.e., CEO(s) are not the relative of the promoter group then elasticity of ROA and

ADJQ with respect to TC is very low 0.1 and 0.08 respectively. Therefore, when CEO is

relative of the promoter group then perhaps the question of whether CEO is Chairman is

immaterial. Anyway the pay-performance elasticity is positive and quite high compare to

the case where CEO is not from the promoter group. Whether CEO is Chairman or not

become a relevant issue when CEO is appointed from the outside world. Table 8 clearly

shows that when CEO is not a relative of the promoter group pay performance elasticity

is less. Further if he/she also becomes the Chairman of the board then moral hazard

problem is at the peak and as a result ROA is inelastic with respect to compensation of

the board because in this case he/she select and dominate all the other board members.

22 Cadbury Committee Report (1992); Kumar Mangalam Birla Committee Report (1999).

32

Table 8:

Variation of elasticity of firm performance with respect to size, proportion of non-executive directors and

pay of the board under four different identity of CEO.

Panels A, B, C and D in this table consider the sample of firms, who’s CEO(s) are relative as well as

Chairman, relative but not Chairman, Chairman but not relative and neither relative nor Chairman

respectively. The two columns in each panel give the results of the regression of log(ROA) and log(ADJQ).

Explanatory variables of interest are log of SIZE, PROP_NED and TC (LSIZE, LPROP_NED and LTC

respectively). Other economic variables are same as discussed earlier. All the regression includes year and

industry fixed effects. P-values are shown in the parenthesis. Panel A Panel B Panel C Panel D

Relative as well as CH Relative but not CH CH but not Relative Neither Relative nor CH Variable

ROA ADJQ ROA ADJQ ROA ADJQ ROA ADJQ

INTERCEPT 4.168*** (<.0001)

0.113 (0.824)

4.292*** (<.0001)

0.552 (0.333)

3.184*** (0.004)

-0.285 (0.847)

3.281*** (<.0001)

0.142 (0.702)

LSIZE -0.222* (0.051)

-0.169 (0.342)

-0.403*** (0.002)

-0.676*** (<.0001)

-0.337 (0.354)

-0.128 (0.790)

-0.207** (0.034)

0.061 (0.631)

LPROP_NED 0.413*** (<.0001)

0.081 (0.591)

0.120 (0.215)

-0.061 (0.639)

-0.077 (0.817)

0.326 (0.527)

0.074 (0.422)

0.068 (0.542)

LTC 0.170*** (<.0001)

0.189*** (<.0001)

0.220*** (<.0001)

0.276*** (<.0001)

0.113 (0.179)

0.266** (0.034)

0.097*** (<.0001)

0.081*** (0.003)

LSALES -0.036 (0.253)

0.058 (0.251)

-0.037 (0.403)

0.125* (0.051)

0.104* (0.094)

0.091 (0.313)

0.026 (0.322)

-0.019 (0.552)

ADVINT 3.938** (0.022)

2.249 (0.392)

2.605 (0.117)

3.390 (0.124)

5.687 (0.163)

19.947*** (0.001)

3.334*** (0.003)

8.702*** (<.0001)

EXPINT 0.125 (0.180)

1.277*** (<.0001)

0.143 (0.290)

0.768*** (<.0001)

0.057 (0.915)

-0.317 (0.709)

0.349** (0.023)

1.637*** (<.0001)

R&DINT -0.700 (0.773)

10.055*** (0.009)

-8.077** (0.033)

-5.658 (0.251)

6.850 (0.561)

2.915 (0.866)

9.135** (0.013)

8.856 (0.101)

DEPINT -1.017 (0.281)

2.382** (0.022)

1.239 (0.425)

3.218** (0.031)

4.182 (0.357)

5.843 (0.379)

-0.091*** (0.003)

0.816 (0.550)

FIRM_AGE -0.002 (0.148)

-0.001 (0.743)

-0.002 (0.199)

-0.003 (0.355)

0.002 (0.549)

-0.003 (0.593)

-0.002* (0.063)

0.001 (0.654)

LEVERG 0.003 (0.771)

-0.047** (0.023)

-0.040* (0.093)

-0.052* (0.072)

0.019 (0.523)

0.025 (0.538)

-0.072*** (0.002)

0.068** (0.013)

D_GROUP -0.273*** (<.0001)

-0.250** (0.031)

-0.096 (0.267)

-0.138 (0.251)

-0.277* (0.093)

-0.451* (0.061)

-0.082 (0.242)

-0.326*** (<.0001)

R-Square 0.47 0.57 0.30 0.46 0.50 0.66 0.19 0.40 Adj R-Sq 0.43 0.52 0.22 0.40 0.30 0.52 0.15 0.37 F 9.75 13.39 3.73 7.11 2.55 4.87 4.54 12.04 N 342 328 293 279 97 96 618 574 *** Significant at 1% level; ** significant at 5% level; * significant at 10% level.

The result can be interpreted as the CEO(s) are from the relative of the promoter group

the cost of information sharing and monitoring become low. So no rent is paid to the

managers and therefore, firm perform better than the others. When CEO is relative as

well as Chairman there may be little scope to corner resources for the family i.e.,

tunnelling, because there will be almost no monitoring. But when there is a different

person (mostly some outsider) in the Chairman post, monitoring the CEO increases and

as a result tunnelling activity becomes low and elasticity becomes high.

33

5.7. Control Variables: Finally in this section I briefly discuss the importance of

eight other economic variables used in all the regression in my analysis. Effect of size of

firm, LSALES, has positive but not significant in most of the cases. R&D expenditure

intensity variable, R&DINT; the advertisement expenditure intensity variables, ADVINT

and the export intensity variable, EXPINT as a fraction of sales have positive effect on

firm performance for most of the cases. The positive sign of the coefficient of R&D

expenditure is consistent with the argument that R&D expenditure is nothing but future

investment for performance. It also helps to get tax reduction for the firm. Positive

coefficient of advertisement expenditure intensity implies that a soft intangible asset

helps to the firm to perform better. Larger sales in foreign markets, export, has positive

impact on firm performance. Depreciation intensity as a fraction of sales, DEPINT has

negative significant effect on most of the cases imply technologically advanced firms

have higher tendencies for better performance Long term debt to equity ratio, LEVERG

has negative significant effect in most of the cases for the large firms i.e., increase in debt

financing reduce the performance of the firm for mostly the firm. For the small firms,

performance of the firm improves with the long-term debt to equity ratio. Dummy for

business group firms, D_GROUP has negative effect on firm performance indicates that

firms belong to business group perform worse than stand alone firms.

6. Conclusion

This paper empirical analyses the effect of corporate governance and

compensation of the board and CEO on the performance of the firm in the emerging

economy, India. Two performance measures are considered in this paper, ROA and

ADJQ for the robustness of the results. Two components of corporate governance that I

consider in this paper are board size and composition i.e., proportion of NED in the

board. This paper provides the evidence of non-linear relation between the two measures

of corporate governance and firm performance. This paper finds that there is a threshold

level on both the size of the board and proportion of NED. The performance of the firms

start falling as the size of the board exceeds 11 or proportion of NED exceeds 73% due to

free riding problem. I substantiate the assertion with linear spline specification. This

finding is different from the studies done with respect to some other developed countries.

34

Most of the literature, discussed above, finds linear relation (positive or negative)

between board structure i.e., board size and proportion of outside directors with firm

performance. The non-linear relation between board size or proportion of NED and firm

performance support the view of the most of the committee reports discussed in Table

1B. Further more the threshold level of board size and proportion of NED substantiate the

recommendation of the most of the committee reports.

The major findings of this paper are, there is significant effect of the

compensation of the board as well as of the CEO on the performance of the firm. There is

a non-linear positive relation between pay and performance of the firm. Pay-performance

sensitivity is high for smaller firms than the larger firms. The reason behind these

findings is, there is scope to improve the performance for the small firms than the large

firms. There is a threshold point at Rs.11 Cr. beyond which the performance start falling.

For lower level of compensation CEO and other directors work in favour of firm. As the

compensation increases CEO as well as other executive directors become reluctant to

work hard and as a result firm performance falls. I also find out that effort made by the

CEO is more useful for the firm than any other directors (executive or non-executive) in

the board, because he/she makes all the decisions for the firm. I find that performance is

more sensitive to the compensation of the CEO than the compensation of the entire

board.

Structure of the compensation also has equally important role in determining the

performance of the firm. I find that to make the directors work in the interest of the

shareholder or value of the share it is necessary to pay large proportion (75 percent) of

compensation in the form of variable compensation, the commission, as most of the

earlier studies suggested. This paper also finds that as the proportion of fixed components

of the board compensation increases moral hazard problem also increases simultaneously

and as a result the performance of the firm falls.

Most of the committee reports of all over the world suggest selecting CEO from

the professional group and there should be distance between CEO and Chairman of the

board. My finding supports the latter recommendation. But my finding also suggests that

if CEO is relative of promoter group then it is not at all harmful for the firm, rather these

firms perform much better than those firms who’s CEO is not the relative of promoter.

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The pay performance elasticity is higher for the firms where CEO(s) are relative of the

promoter group. Further it becomes highest for the case CEO is relative but not Chairman

of the firm. The reason comes from the perspective of institution; ‘loyalty’ plays a very

crucial role here. Since they established the firm and they also have largest stake in the

firm so, the moral hazard problem is least. The post of Chairman and CEO should be

separated when CEO is not an insider, i.e., not relative of the promoter group because

moral hazard problem in this case is strongest.

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