The Managerial Power Theory of Executive Compensation
by Paul J. Schneider, JD, LLM Abstract: As a consequence of the disconnect between executive compensation and the financial meltdown that battered the economy as a whole, the academic community is developing a new theory of executive compensation, which is referred to as the managerial power theory of executive compensation. The proponents of this theory argue that the current system of corporate governance unavoidably creates incentives and psychological and social forces that distort executive compensation. These proponents make several recommendations to provide executives with well designed and cost-effective compensation programs that will generate shareholder value. Planners should be knowledgeable about these coming changes because they could very well be considered “best practices” in the near future, and as such could establish the standard by which the executive compensation programs for nonpublicly held companies will be measured.
as well as government regulators. Moreover, publicly traded companies are more critically reviewing their existing compensation plans and structures to make sure that they are properly adapted to the current economic and financial environment. Thus, this is an appropriate time for financial service professionals to look from a theoretical and conceptual standpoint at how the academic community is analyzing executive compensation and in particular, the long-term trend of increasing CEO pay. Pay for Performance and Optimal Contracting Before the financial crisis, the predominant trend in executive compensation was to improve the correlation between pay and performance so that the interests of shareholders and top executives would be aligned. Consequently, as boards of directors sought to achieve pay for performance, one outcome of the trend was to place more emphasis on performance-vested equity compensation for top executives. This approach was thought to tie an increased portion of executive compensation to long-term performance as measured by total shareholder return or to performance metrics that drive shareholder return. This approach led to increasingly higher compensation for the top executives. But since share prices were growing as well, shareholders made money right alongside the executives so everyone was happy. The financial crisis brought about
Even as the financial meltdown of 2007-2009 (the “financial crisis”) recedes into the rearview mirror, executive compensation continues to attract the attention of the academic community, particularly those specializing in finance, economics, corporate law, and corporate governance; and it continues to be scrutinized by institutional investors, proxy advisory firms,
This issue of the Journal went to press in April 2013. Copyright © 2013, Society of Financial Service Professionals. All rights reserved.
heightened skepticism with respect to the degree to which pay for performance was a workable concept. Amidst one of the worst financial meltdowns since the Great Depression, executives and their large paychecks, especially in the financial industry, became the targets of criticism from the media, the regulators, elected officials, and the academic community. For example, there were mortgage company executives who were paid bonuses based on the volume of mortgages sold without regard to the quality of those loans. There were also derivative securities issued where the executive in charge received a bonus based on the volume of such securities issued without taking into account the risks to the issuer’s capital related to such securities. Prior to the financial crisis the prevailing economic theory behind executive compensation was referred to as the optimal contracting theory. The key assumption of this theory is that top executives and shareholders, through the board of directors, negotiate at arm’s length over pay, with each side trying to...
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