This paper examines legal rules covering protection of corporate shareholders and creditors, the origin of these rules, and the quality of their enforcement in 49 countries. The results show that common law countries generally have the best, and French civil law countries the worst, legal protections of investors, with German and Scandinavian civil law countries located in the middle. We also find that concentration of ownership of shares in the largest public companies is negatively related to investor protections, consistent with the hypothesis that small, diversified shareholders are unlikely to be important in countries that fail to protect their rights.

Law and Finance

This paper examines legal rules covering protection of corporate shareholders and creditors, the origin of these rules, and the quality of their enforcement in 49 countries. The results show that common-law countries generally have the strongest, and Frenchcivil-law countries the weakest, legal protections of investors, with German- and Scandinavian-civil-law countries located in the middle. We also find that concentration of ownership of shares in the largest public companies is negatively related to investor protections, consistent with the hypothesis that small, diversified shareholders are unlikely to be important in countries that fail to protect their rights.

This paper surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world.

A Survey of Corporate Governance

This article surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world. CORPORATE GOVERNANCE DEALS WITH the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers? At first glance, it is not entirely obvious why the suppliers of capital get anything back. After all, they part with their money, and have little to contribute to the enterprise afterward. The professional managers or entrepreneurs who run the firms might as well abscond with the money. Although they sometimes do, usually they do not. Most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to the providers of finance. But this does not imply that they have solved the corporate governance problem perfectly, or that the corporate governance mechanisms cannot be improved. In fact, the subject of corporate governance is of enormous practical impor

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We use data on ownership structures of large corporations in 27 wealthy economies to identify the ultimate controlling shareholders of these firms. We find that, except in economies with very good shareholder protection, relatively few of these firms are widely held, in contrast to Berle and Means’s image of ownership of the modern corporation. Rather, these firms are typically controlled by families or the State. Equity control by financial institutions is far less common. The controlling shareholders typically have power over firms significantly in excess of their cash f low rights, primarily through the use of pyramids and participation in management.

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Corporate Ownership Around the World

This paper provides an overview of the main theoretical elements and empirical underpinnings of a managerial power approach to executive compensation. Under this approach, the design of executive compensation is viewed not only as an instrument for addressing the agency problem between managers and shareholders but also as part of the agency problem itself. Boards of publicly traded companies with dispersed ownership, we argue, cannot be expected to bargain at arm's length with managers. As a result, managers wield substantial influence over their own pay arrangements, and they have an interest in reducing the saliency of the amount of their pay and the extent to which that pay is de-coupled from managers' performance. We show that the managerial power approach can explain many features of the executive compensation landscape, including ones that many researchers have long viewed as puzzling. Among other things, we discuss option plan design, stealth compensation, executive loans, payments to departing executives, retirement benefits, the use of compensation consultants, and the observed relationship between CEO power and pay. We also explain how managerial influence might lead to substantially inefficient arrangements that produce weak or even perverse incentives.

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Executive Compensation as an Agency Problem

Among financial economists, the dominant approach to the study of executive compensation views managers' pay arrangements as a (partial) remedy to the agency problem. Under this approach, which we label the “optimal contracting approach,” boards are assumed to design compensation schemes to provide managers with efficient incentives to maximize shareholder value. Financial economists have done substantial work within this optimal contracting model in an effort to understand executive compensation practices; recent surveys of this work include Murphy (1999) and Core, Guay and Larcker (2001). To some researchers working within the optimal contracting model, the main flaw with existing practices seems to be that, due to political limitations on how generously executives can be treated, compensation schemes are not sufficiently high-powered (Jensen and Murphy, 1990). Another approach to studying executive compensation focuses on a different link between the agency problem and executive compensation. Under this approach, which we label the “managerial power approach,” executive compensation is viewed not only as a potential instrument for addressing the agency problem but also as part of the agency problem itself. As a number of researchers have recognized, some features of pay arrangements seem to reflect managerial rent-seeking rather than the provision of efficient incentives (for example, Blanchard, Lopez-de-Silanes and Shleifer, 1994; Yermack, 1997; and Bertrand and Mullainathan, 2001). We seek to develop a full account of how managerial influence shapes the executive compensation landscape in a forthcoming book (Bebchuk and Fried, 2004) that builds substantially on a long article written jointly with David Walker (Bebchuk, Fried and Walker, 2002).

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This book provides a detailed account of how structural flaws in corporate governance have enabled managers to influence their own pay and produced widespread distortions in pay arrangements. The book also examines how these flaws and distortions can best be addressed. Part I of the book (titled The Official View and its Limits) critically examines the arm's length contracting view, which underlies much of the academic research on executive compensation as well as the law's approach to it. We show that boards have not been operating at arm's length from the executives whose pay they set. While recent reforms can improve matters, they cannot be expected to eliminate significant deviations from arm's length contracting. We also show that the constraints imposed by market forces and shareholders' power to intervene are not tight enough to prevent such deviations. Part II of the book (titled Power and Pay) shows how an understanding of the role of managerial power can help explain executive compensation practices. We provide a framework for assessing whether pay arrangements are a product of managerial influence. We discuss managers' interest in camouflaging the amount and the performance-insensitivity of their pay. Applying our framework, we discuss how managerial influence can help explain, among other things, the evidence on the relationship between managerial pay and managerial power; the use of retirement benefits and other compensation arrangements to provide stealth compensation; and the ability of departing managers to obtain more than their contractual entitlement. Part III of the book (titled Decoupling Pay from Performance) examines how managerial influence has operated to reduce the performance-sensitivity of executive pay. Among other things, we examine the structure of non-equity compensation, the design of conventional option plans, the use of restricted stock grants, and managers' freedom to unload options and shares. Part IV of the book (titled Going Forward) discusses how executive compensation - and corporate governance more generally - can be improved. We examine the extent to which pay arrangements can be improved by adopting board process rules, imposing shareholder approval requirements, and making pay more transparent. We conclude that problems with compensation arrangements cannot be fully addressed without ensuring that directors focus on shareholder interests and operate at arm's length from the executives whose compensation they set. To achieve this result, we argue, it is not sufficient to make directors independent of executives as recent reforms has sought to do; it is also necessary to make directors dependent on shareholders by changing the legal arrangements that insulate boards from shareholders.

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Pay without Performance: The Unfulfilled Promise of Executive Compensation

This paper contains a draft of Part III of our forthcoming book, Pay without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press, September 2004). The book provides a detailed account of how structural flaws in corporate governance have enabled managers to influence their own pay and produced widespread distortions in pay arrangements. The book also examines how these flaws and distortions can best be addressed. Part III of the book examines how managerial influence has operated to reduce the performance-sensitivity of executive pay. Among other things, we examine the structure of non-equity compensation, the design of conventional option plans, the use of restricted stock grants, and managers’ freedom to unload options and shares.

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Pay without Performance, The Unfulfilled Promise of Executive Compensation, Part III: The Decoupling of Pay from Performance

This Article develops an account of the role and significance of managerial power and rent extraction in executive compensation. Under the optimal contracting approach to executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value. In contrast, the managerial power approach suggests that boards do not operate at arm’s length in devising executive compensation arrangements; rather, executives have power to influence their own pay, and they use that power to extract rents. Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements. Examining the large body of empirical work on executive compensation, the authors show that managerial power and the desire to camouflage rents can explain significant features of the executive compensation landscape, including ones that have long been viewed as puzzling or problematic from the optimal contracting perspective. The authors conclude that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.

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Lucian Arye Bebchuk

Papers

Executive Compensation as an Agency Problem

Executive Compensation as an Agency Problem

Pay without Performance: The Unfulfilled Promise of Executive Compensation

Pay without Performance, The Unfulfilled Promise of Executive Compensation, Part III: The Decoupling of Pay from Performance

Managerial Power and Rent Extraction in the Design of Executive Compensation