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ween CEO compensation and
the proportion of outside directors. In the case of China, outside expertise, and especially foreign
know-how, can be critical to a firm’s success. The proportion of outside directors should therefore
be positively associated with CEO compensation. Still, the presence of outside directors is limited
among Chinese firms. Most of them are state and/or legal person representatives.6 The situation
is likely to change, however, following new corporate governance rules drafted by the Chinese
government.7 For that reason, a high proportion of outside directors can be seen as an indicator
that firms are already adhering to global management standards. Since those standards also imply
a higher degree of acceptance of large CEO-average employee pay differential, we expect CEO
compensation to increase with the proportion of outside directors.
2.2. Ownership variables
CEO shareholding measures the proportion of the firm’s equity held by the CEO. Jensen and
Meckling (1976) emphasize the role of executive stock ownership as a mechanism to align the
interests of managers and shareholders, and promote greater managerial efforts as well as stricter
value enhancing decisions. When managers have only a small stake in the firm, executive stock
ownership plans can be used for reducing the fixed (cash) portion and increasing the variable
(stock-related) portion of CEO compensation. As a result, there should be a negative relation
between cash compensation and share ownership. Allen (1981), Lambert et al. (1993) and Core et
al. (1999) confirm that the level of U.S. CEOs’ compensation is typically a decreasing function of
the equity held by the CEO. In start up firms, where cash is habitually limited and the objective is to
create share value, stock ownership and stock options plans are extensively used as substitutes for
cash compensation (Ittner et al., 2003; Murphy, 2003). Newly privatized Chinese firms, however,
consist mostly of manufacturing firms that have yet to develop the culture of stock option plans.8
Cash compensation and stock ownership plans are used concurrently to remunerate top managers.
In fact, stock ownership can serve to identify and retain the best managers and defer, but not
reduce, cash compensation.We therefore expect to find a positive association between CEO share
ownership and compensation in China, in contrast to the case of U.S. firms.
Only large shareholders have the incentive to monitor managers compared with dispersed
shareholders whose monitoring costs are too high to justify the effort considering their small
6 See Table 2 for further details.
7 Following a report prepared by Lehman Brothers, a U.S. investment bank, the Chinese authorities have drafted new
rules requiring at least one-third of company board members to be independent appointees, and at least one independent
director to be a professional accountant. In the current ownership system, only the first and second largest shareholders
have the right to nominate outside directors.
8 About two-third of our sample consists of industrial (manufacturing) firms. This proportion reflects the developing
status of the Chinese economy as well as the greater likelihood of industrial firms to be privatized because of their higher
profitability.38 D. Li et al. / Research in International Business and Finance 21 (2007) 32–49
may therefore slightl