Executive Compensation as an Agency Problem

TLDR: In this paper, the authors provide an overview of the main theoretical elements and empirical underpinnings of a managerial power approach to executive compensation, arguing that 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 pay is de-coupled from managers' performance.

Abstract: 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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ISSN 1045-6333
HARVARD
JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS
EXECUTIVE COMPENSATION AS
AN AGENCY PROBLEM
Lucian Arye Bebchuk and Jesse M. Fried
Discussion Paper No. 421
04/2003
Harvard Law School
Cambridge, MA 02138
The Center for Law, Economics, and Business is supported by
a grant from the John M. Olin Foundation.
This paper can be downloaded without charge from:
The Harvard John M. Olin Discussion Paper Series:
http://www.law.harvard.edu/programs/olin_center/
The Social Science Research Network Electronic Paper Collection:
http://papers.ssrn.com/abstract_id=364220
This paper is also a discussion paper of the
John M. Olin Center's Program on Corporate Governance.

Last revision: April 2003
Executive Compensation as an Agency Problem
Lucian Arye Bebchuk* and Jesse M. Fried**
Abstract
This paper provides an overview of the main theoretical elements and
empirical underpinnings of a “managerial power” approach to executive
compensation. The managerial power approach recognizes that boards of publicly
traded companies with dispersed ownership do not bargain at arms’ length with
managers, and that managers are able to influence their own pay arrangements. It
thus views executive compensation not only as an instrument for addressing the
agency problem between managers and shareholders, but also as part of the
problem itself. We show that the managerial power approach can help explain many
features of the executive compensation landscape, including ones that researchers
have long viewed as puzzling. We explain that managerial influence produces
efficiency costs because managers’ seeking and camouflaging of rents produces
inefficient arrangements that result in weak or even perverse incentives.
Keywords: Corporate governance, managers, shareholders, boards, directors,
executive compensation, stock options, principal-agent problem, agency costs, rent
extraction, golden parachutes, executive loans, compensation consultants.
JEL classification: D23, G32, G34, G38, J33, J44, K22, M14.
* William J. Friedman Professor of Law, Economics, and Finance, Harvard Law School, and
Research Associate, National Bureau of Economic Research. E-mail: bebchuk@law.havard.edu.
** Professor of Law, Boalt Hall School of Law, University of California at Berkeley. E-mail:
friedj@law.berkeley.edu.
We would like to thank J. Bradford De Long, Alexandra McCormack, Andrei Shleifer,
Timothy Taylor, and Michael Waldman for their valuable suggestions. For financial support, we
are grateful to the John M. Olin Center for Law, Economics, and Business (Bebchuk) and to the
Boalt Hall Fund and U.C. Berkeley Committee on Research (Fried).
© 2003 Lucian Bebchuk and Jesse Fried. All rights reserved.

Executive compensation has long attracted a great deal of attention from
financial economists. Indeed, the increase in academic papers on the subject of CEO
compensation during the 1990’s seems to have outpaced even the remarkable
increase in total CEO pay itself during this period (Murphy (1998)). Much research
has focused on how executive compensation schemes can help alleviate the agency
problem in publicly traded companies. To adequately understand the landscape of
executive compensation, however, it is necessary to recognize that compensation
schemes are also partly a product of this same agency problem.
I. ALTERNATIVE APPROACHES TO EXECUTIVE COMPENSATION
Our focus in this paper is on publicly traded companies without a controlling
shareholder. When ownership and management are separated in this way,
managers might have a substantial degree of power. This recognition goes back, of
course, to Berle and Means (1933) who observed that “[D]irectors, while in office,
have almost complete discretion in management” (p. 139). Since Jensen and
Meckling (1976), the problem of managerial power and discretion has been analyzed
in modern finance as an “agency problem.”
Managers may use their discretion to benefit their private interests in a
variety of ways (Shleifer and Vishny (1997)). For example, managers may engage in
empire building (Jensen, (1974), Williamson (1964)). They may, as Jensen (1986)
suggests, fail to distribute excess cash when the firm does not have profitable
investment opportunities. Managers also may entrench themselves in their
positions, making it difficult to oust them when they perform poorly (Shleifer and
Vishny (1989)). Any discussion of executive compensation must proceed against the
background of the fundamental agency problem afflicting management decision-
making. There are two different views, however, on how the agency problem and
executive compensation might be linked.
Among financial economists, the dominant approach to the study of
executive compensation views these pay arrangements as a (partial) remedy to the
agency problem. Under this approach, which we label “the optimal contracting
approach,” compensation schemes are assumed to be designed by boards seeking 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
on executive compensation from an optimal contracting perspective include
Murphy (1999) and Core, Guay, and Larcker (2001). To researchers working within
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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, which we label the
“managerial power approach,” focuses on a different link between the agency
problem and executive compensation. Under this approach, executive compensation
is viewed not only as a potential instrument for addressing agency problems – 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 (e.g., Blanchard, Lopez-de-
Silanes, and Shleifer, (1994), Yermack (1997), and Bertrand and Mullainathan
(2001)). Building on this research, 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)).
Drawing on this work, we argue below that managerial power and rent
extraction are likely to have an important influence on the design of compensation
arrangements. Indeed, as an empirical matter, the managerial power approach can
shed light on many significant features of the executive compensation landscape
that have long been seen as puzzling by researchers working within the optimal
contracting model. We also explain that managerial influence on pay might impose
substantial costs on shareholders – beyond the excess pay executives receive – by
diluting and distorting managers’ incentives and thereby hurting corporate
performance.
Although the managerial power approach is conceptually quite different from
the optimal contracting approach, the former is not proposed as a complete
replacement for the latter. Compensation arrangements might be shaped both by
market forces that push toward value-maximizing arrangements, and by the
influence of managerial power, leading to departures from these arrangements in
directions favorable to managers. The managerial power approach simply claims
that these departures from value-maximizing arrangements are substantial and that
compensation practices thus cannot be adequately explained by optimal contracting
alone.
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II. THE LIMITATIONS OF OPTIMAL CONTRACTING
The optimal contracting view recognizes that managers suffer from an agency
problem and do not automatically seek to maximize shareholder value. Thus,
providing managers with adequate incentives is important. Under the optimal
contracting view, the board, working in shareholders’ interest, attempts to cost-
effectively provide managers such incentives through their compensation packages.
Optimal compensation contracts could result either from effective arm’s length
bargaining between the board and the executives, or from market constraints that
induce players to adopt such contracts even in the absence of arm’s length
bargaining. However, neither of these forces can be expected to constrain effectively
departures from arm’s length outcomes.
1
Just as there is no reason to presume that managers automatically seek to
maximize shareholder value, there is no reason to expect a priori that directors will
either. Indeed, an analysis of directors’ incentives and circumstances suggests that
directors’ behavior is also subject to an agency problem. The director agency
problem undermines the board’s ability to effectively address the agency problems
in the relationship between managers and shareholders.
Directors have an incentive to be re-appointed to the board. Average director
compensation in the 200 largest US corporations in 2001 was $152,626 (Pearl Meyers
and Partners (2002)). In the notorious Enron case, the directors were each paid
$380,000 in 2001 (Abelson (2001)). Besides an attractive salary, a directorship is also
likely to provide prestige and valuable business and social connections. Thus,
directors often have an incentive to favor the CEO because of the important role
CEO’s play in re-nominating directors to the board.
To be sure, in a world in which shareholders selected individual directors,
directors might have an incentive to develop reputations as shareholder-serving.
However, because board elections are by slate and dissidents putting forward their
own director slate confront substantial impediments, such challenges are
exceedingly rare (Bebchuk and Kahan (1990)). Typically, the director slate proposed
by management is the only one offered.
The key to a board position is thus being on the company’s slate. Because the
CEO’s influence over the board gives her significant influence over the nomination
process, directors have an incentive to “go along” with the CEO’s pay arrangement,
a matter dear to the CEO’s heart, at least as long as the compensation package
1
Shareholders could try to challenge undesirable pay arrangements in court. However,
corporate law rules effectively prevent courts from reviewing compensation decisions.
(Bebchuk, Fried, and Walker (2002), at 779-781).
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Frequently asked questions

Q1. What have the authors contributed in "Executive compensation as an agency problem" ?

This paper provides an overview of the main theoretical elements and empirical underpinnings of a “ managerial power ” approach to executive compensation. The authors show that the managerial power approach can help explain many features of the executive compensation landscape, including ones that researchers have long viewed as puzzling. The authors explain that managerial influence produces efficiency costs because managers ’ seeking and camouflaging of rents produces inefficient arrangements that result in weak or even perverse incentives. 

Q2. What future works have the authors mentioned in the paper "Executive compensation as an agency problem" ?

The authors hope that future studies of executive compensation will devote to the role of managerial power as much attention as the optimal contracting model has received. 

Q3. What is the main flaw with existing compensation schemes?

To researchers working withinthe 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)). 

Q4. What is the way to filter out the increase in the stock price?

Given the wide variety of reduced-windfall options available and their potential benefits, it is likely that in a considerable number of firms it would be optimal to filter out at least some of the increase in the stock price that has nothing to do with the managers’ efforts. 

Q5. How does the extent of managerial influence affect compensation arrangements?

The extent to which managerial influence can move compensation arrangements away from optimal contracting outcomes depends on the extent to which market participants, especially institutional investors, are aware of, and on guard against, the problems the authors have discussed. 

Q6. How would an executive receive a payout under a reduced-windfall plan?

Under such an option plan, executives would have on average an 80 percent probability of outperforming the benchmark and receiving a payout. 

Q7. What is the explanation for why firms do not use reduced-windfall options?

If it were desirable to have an automatic mechanism that provides managers with greater incentive to remain in the company during stock market booms, it would be more cost-effective to provide executives with reduced-windfall options and to automatically issue them new and completely unvested (reduced-windfall) options. 

Q8. What is the effect of a blackout period on the firm’s profits?

Because a firm can be held liable if it fails to take reasonable steps to prevent insider trading by its employees, a number of firms have adopted “trading windows” and “blackout periods” to restrict the times during the year that a manager can sell or buy shares (Bettis, Coles, and Lemmon (2000)). 

Q9. What is the link between pay and performance?

In light of the historically weak link between managerial performance and their non-equity compensation, shareholders and others have increasingly looked to equity-based compensation to provide the desired link between pay and performance. 

Q10. What is the way to provide managers with incentives to exert effort?

An optimally designed scheme would seek to provide risk-averse managers with cost-effective incentives to exert effort and make value-maximizing decisions. 

Q11. What is the way to explain the lack of a real movement toward reduced-windfall?

Given that using conventional options is clearly legitimate and acceptable (most firms use them), and that moving to indexing or any other form of reduced-windfall options is likely to be costly or inconvenient for managers, the lack of any real movement toward such options is consistent with the managerial power approach. 

Q12. What are the reasons for concluding that managerial power has a substantial influence on the design?

There are good theoretical and empirical reasons for concluding thatmanagerial power has a substantial influence on the design of executive compensation in companies marked by a separation of ownership and control. 

Q13. What is the significance of the conclusion that managerial power and rent extraction play an important role in executive?

The conclusion that managerial power and rent extraction play an important role in executive compensation has significant implications for corporate governance, which the authors explore in their forthcoming book. 

Q14. What is the common reason why managers have been able to use their influence to obtain options?

however, managers have been able to use their influence to obtain option plans that appear to deviate substantially from optimal contracting in ways that favor managers.