NON-EXECUTIVE DIRECTOR COMPENSATION AND CORPORATE RISK-TAKING

Abstract

This study examines how the different forms of compensation for non-executive directors (“NEDs”) affect corporate risk-taking, as reflected in research and development expenditures. The recent collapse of financial giants such as Bear Stearns and Lehman Brothers has drawn considerable attention to the excessive risk-taking behavior of managers. Recent literature has also focused on the role of the managers in corporate risk-taking. However, the role played by the board of directors in corporate risk-taking has been neglected. As monitors of the management, the board of directors has significant influence over the choice of management and corporate decisions. The incentives received by the board of directors will impact the corporate decision-making process and the amount of risks that the firm undertakes. In particular, the NEDs are important as they are supposed to provide independent and objective judgment to the firm. I find that a higher percentage of cash-based compensation for NEDs results in the firm taking less risk while a higher percentage of equity-based compensation for NEDs results in the firm taking more risk. I also find that the increase in corporate risk-taking caused by the increase in percentage of equity-based compensation is mainly driven by an increase in the percentage of option-based compensation received by the NEDs. In additional analysis, I find that there is a non-linear, U-shaped relationship between the percentage of stock-based compensation for NEDs and corporate risk-taking. Finally, I also find that firms that pay a higher percentage of cash-based compensation to NEDs perform better in the short term and firms that pay a higher percentage of stock-based compensation to NEDs perform worse in the long term.