Legal Institutions, Board Diligence, and Top Executive Pay


*Humboldt-University Berlin and Stanford University, Graduate School of Business, 518 Memorial Way, Stanford, CA 94305. E-mail:


Manuscript Type: Empirical

Research Question/Issue: We examine whether anti-director laws and legal director liability rules affect the diligence of directors in setting the compensation of CEOs. The study uses a world-wide data set covering 27 countries for the period 1995 to 2005.

Research Findings/Results: Controlling for a number of legal and economic determinants, we find that independent of managerial risk-aversion, CEO pay is always less generous under stricter anti-director rules and a stronger rule of law. Director liability rules are associated with more generous pay schemes. The results persist once we control for the presence of institutional investors and cross-listing in the US.

Theoretical Implications: Our results suggest that there exists an agency conflict between shareholders and outside directors reflected in the degree to which directors act diligently when negotiating the pay contract with the CEO. However, this conflict may be alleviated by specific legal rules making boards more accountable to shareholders. Private measures of shareholder protection do not seem entirely capable of substituting for legal institutions.

Practical Implications: Reducing managerial agency cost is commonly viewed as a desirable policy goal. We advocate the view that specific legal institutions that strengthen procedural rights of shareholders' voting on directors and the overall quality of the legal system help to achieve this goal. Director liability rules, however, appear to be ineffective for this purpose.