Incentive contracting when boards have related industry expertise

- Propose model of optimal contracting when directors have industry expertise (DRIs).
- Show DRIs reduce CEO pay and forced-turnover sensitivity to firm performance.
- DRI effect stronger if sector is differentiated and stock price is less informative.
- DRI effect reflects an information role rather an agency problem.
- DRIs reduce sensitivity of CEO pay to industry performance.

We posit that presence of informed directors, by enhancing the board's information and ability to advise and monitor management, will affect the nature of incentive contracts offered to CEOs. In particular, we study the effect of directors from related industries (DRIs) i.e., downstream or upstream industries: our premise is that DRIs contribute information about product-market prospects. Using a simple optimal-contracting model to develop testable predictions, we hypothesize that DRIs reduce a firm's reliance on stock-based incentives. Our empirical evidence is strongly supportive: CEO pay and replacements are less sensitive to stock performance, particularly when industry-related information is crucial and when stock price is less informative.