Is executive compensation influenced by the composition of the Board of Directors? About one in
ten Chief Executive Officers (CEOs) is "reciprocally interlocked" with another CEO -- a current or
retired CEO of firm A serves as a director of firm B and a current or retired CEO of firm B serves as
a director of firm A. An even larger fraction (20%) of firms have at least one current or retired
employee sitting on the board of another firm and vice versa, which is larger than would be expected if
directors were randomly assigned to board positions. I investigate how these and other features of board
composition affect CEO pay. I use a newly assembled sample of nearly 10,000 director positions in
America’s largest companies, collected from annual reports, together with information on firm value,
recent stock returns, and other determinants of CEO salary. Chief executives heading interlocked firms
earn significantly higher compensation. After controlling for firm and CEO characteristics, however,
interlocking directorates are associated with at most 10% higher pay. Furthermore, there is some
evidence that this return is getting smaller over time.

We investigate the impact of changes in states’ anti-takeover legislation on executive compensation.
We find that both pay for performance sensitivities and mean pay increase for the firms affected by
the legislation (relative to a control group). These findings are partially consistent with an optimal
contracting model of CEO pay as well as with a skimming model in which reduced takeover fears
allow CEOs to skim more. We compute lower bounds on the relative risk aversion coefficients
implied by our findings. These lower bounds are relatively high, indicating that the increase in
mean pay may have been more than needed to maintain CEOs’ individual rationality constraints.
Under both models however, our evidence shows that the increased pay for performance offsets
some of the incentive reduction caused by lower takeover threats.

Measured individual performance often depends on random factors which also
affect the performances of other workers in the same firm, industry, or market. In
these cases, relative performance evaluation (RPE) can provide incentives while
partially insulating workers from the common uncertainty. Basing pay on relative
performance, however, generates incentives to sabotage the measured performance of
co-workers, to collude with co-workers and shirk, and to apply for jobs with inept
co-workers. RPE contracts also are less desirable when the output of co-workers is
expensive to measure or in the presence of production externalities, as in the case of
team production.
The purpose of this paper is to review the benefits and costs of RPE and to test
for the presence of RPE in one occupation where the benefits plausibly exceed the
costs: top-level management. Rewarding chief executive officers (CEOs) based on
performance measured relative to the industry or market creates incentives to take
actions increasing shareholder wealth while insuring executives against the vagaries
of the stock and product markets that are beyond their control. We expect RPE to be
a common feature of implicit CEO compensation and dismissal contracts because the
potential benefit of filtering out common uncertainty is high, the cost of measuring the
performance of other firms is small, and opportunities for sabotage and collusive
shirking are limited.
In contrast to previous research, our empirical evidence strongly supports the
RPE hypothesis-—CEO pay revisions and retention probabilities are positively and
significantly related to firm performance, but are negatively and significantly related
to industry and market performance, ceteris paribus. Our results also suggest that
CEO performance is more likely to be evaluated relative to aggregate market
movements than relative to industry movements.