By Ye Cai, Santa Clara University Leavey School of Business; Jin Xu, Virginia Tech Pamplin College of Business; and Jun Yang, Indiana University Kelley School of Business


To what extent are independent directors truly independent, and does a narrow focus on transaction-based financial ties obscure another area of potential conflicts of interest, namely corporate charitable donations?

Stock-exchange rules establishing directors’ independence are typically based on transaction-based financial ties, and most research classifies independent directors based on this limited assessment. However, independent directors may have other ties to top executives that interfere with their exercise of independent judgment in carrying out responsibilities.

In our forthcoming paper in the Review of Financial Studies, Paying by Donating: Corporate Donations Affiliated with Independent Directors, we investigate a new factor of director independence: material relationships between independent directors and top executives via corporate charitable contributions to tax-exempt organisations affiliated with independent directors (affiliated donations).

Corporate donations help fulfil directors’ fundraising obligations at their affiliated charities, creating a potential conflict of interest that can negatively impact directors carrying out monitoring responsibilities. Because corporate charitable contributions are rarely disclosed in companies’ filings with the Securities and Exchange Commission (SEC), they have been largely overlooked in corporate governance research until very recently.

In this study, we test whether CEOs gain leverage over independent directors by channelling corporate donations to directors’ affiliated charities. We examine the causes of affiliated donations and their effect on board monitoring.

We find that firms with weaker board oversight and shareholder monitoring are more likely to make affiliated donations, and such donations are larger. Moreover, long-tenured directors and directors affiliated with more charities tend to receive corporate donations.

Interestingly, affiliated donations typically begin after an independent director’s appointment to the corporate board that connects the firm and the charity, and they end after his or her departure for exogenous reasons (such as death or retirement) that sever the connection. This indicates that affiliated donations target independent directors rather than particular charitable causes.

To examine the effects of affiliated donations, we focus on CEO compensation practices; CEO replacement decisions and firm performance.

Greater CEO compensation and retention of a poorly performing CEO are often signs of governance failures. We find that firms making affiliated donations pay their CEOs 9.4% more on average than firms not making affiliated donations.

To identify how affiliated donations affect CEO compensation, we contrast donations made to charities affiliated with independent directors serving on the compensation committee with those made to charities involving other independent directors.

We show that the positive association between affiliated donations and the level of CEO compensation is significant only when affiliated donations involve compensation committee members. On average, at firms that donate to charities affiliated with the compensation committee chair, CEO compensation is 15.6% higher than it is at firms that do not make affiliated donations.

It is possible that the positive association between affiliated donations and CEO compensation is driven by factors beyond the firm, CEO, and governance characteristics included in our analyses.

To address such concerns, we examine changes in CEO compensation around the initiation and termination of affiliated donations and conduct a series of robustness tests.

We further control for alternative channels such as unaffiliated donations, CEO-affiliated donations, inside director-affiliated donations, CEO-director ties at affiliated charities, and free cash flow. The positive correlation between affiliated donations and CEO compensation continues to hold in all the tests.

Because it is impossible to exhaust all the factors that may drive the positive correlation between affiliated donations and CEO compensation, we establish a causal effect of affiliated donations on CEO compensation by looking at college basketball and football head coach firing. We focus on these events because over 40% of affiliated donations go to educational institutions and forced turnovers of college head coaches are very common.

Firing a coach for poor performance and revamping the team can cost millions of dollars[1]. Head coach terminations tend to happen after a prolonged period of poor performance, when advertisement revenue and alumni donations are below expectations.

Under pressure to fundraise, independent directors who are affiliated with universities greatly appreciate CEOs’ understanding and corporate contributions at these critical moments, and this appreciation may weaken their monitoring incentive.

Importantly, college coach replacement is unlikely to be related to CEO compensation. It affects CEO compensation only through a firm’s decision to make affiliated donations in response to the increased demand for funding. Our analysis shows that CEO compensation increases with affiliated donations predicted by forced turnovers of college coaches. This helps establish the effect of affiliated donations on CEO compensation.

In addition to their effect on CEO compensation, we examine how affiliated donations affect CEO replacement decisions – another important monitoring task performed by boards. Poor firm performance is often used as a proxy for low CEO ability.

Retaining a low-ability CEO can be costly to shareholders. We show that affiliated donations weaken the link between forced CEO turnover and firm performance: a CEO is unlikely to be replaced for poor performance if the firm donates to charities affiliated with a large fraction of the board or if the firm makes large affiliated donations.

Lastly, if affiliated donations weaken board monitoring effectiveness, we expect firm performance and shareholder value to be negatively affected. Our tests, using various measures of stock and accounting performance, show that this is indeed the case.

Our research shows that affiliated donations weaken independent directors’ monitoring incentives at the expense of taxpayers and shareholders. We suggest that regulators mandate the disclosure of affiliated donations in SEC filings that are easily accessible to investors (e.g., in firms’ proxy statements). Such disclosure would help inform shareholders of independent directors’ potential conflicts of interest, leading to a more accurate definition of director independence.

The complete paper is available here.



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